There are some analysts who continue to use book value
weights and justify them using three arguments, none of
which are convincing:
1.Bookvalueismorereliablethanmarketvaluebecauseitis
not as volatile. While it is true that book value does not
changeasmuchasmarketvalue,thisismoreareflectionof
weakness than strength, since the true value of the firm
changesovertimeasnewinformationcomesoutaboutthe
firmandtheoveralleconomy.Wewouldarguethatmarket
value,withits volatility,isamuchbetterreflectionoftrue
value than is book value.
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- Using book value rather than market value is a more
conservative approach to estimating debt ratios. The book
valueofequityinmost firmsindeveloped marketsiswell
below thevalueattached bythemarket, whereasthe book
valueof debtisusuallycloseto themarketvalue ofdebt.
Sincethecostofequityismuchhigherthanthecostofdebt,
thecostofcapitalcalculatedusingbookvalueratioswillbe
lowerthanthosecalculatedusingmarketvalueratios,making
them less conservative estimates, not more so.
52 - Since accounting returns are computed based on book
value, consistency requires the use of book value in
computingcost ofcapital.Whileitmayseemconsistentto
usebookvaluesforbothaccountingreturnandcostofcapital
calculations, it does not make economic sense. The funds
invested in this firm can be invested elsewhere, earning
marketrates,andthecostsshouldthereforebecomputedat
market rates and using market value weights.