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Cost of Capitalintermediate

Capital Structure Weights

The WACC weights are the fractions of total invested capital supplied by each source, and the first decision is market versus book values. Weights must use market values, because they show the real importance of each financing source today. Book weights freeze the past and can badly misstate the mix. A second refinement is target weights. If the firm plans to change its debt-equity mix, the weights should reflect the planned structure that investors will be financing, not the current snapshot.

Try it yourself

Building the after-tax WACC

A firm's cost of capital is the market-value-weighted blend of what debt and equity holders require: WACC = w_d·k_d·(1 − T) + w_e·k_e. Equity is priced by the CAPM, k_e = r_f + β·ERP, while debt is taken after the interest tax shield, k_d·(1 − T). Only debt earns the shield, so it usually sits below equity in the blend.

Weighted average cost of capital7.50%
0%2%4%6%8%10%12%1.80%5.70%WACC 7.50%Debt w_d·k_d·(1 − T)Equity w_e·k_e
Cost of equity k_e 9.50%After-tax k_d 4.50%WACC 7.50%
Weight of debt w_d40%
Equity weight w_e = 60%
Pre-tax cost of debt k_d6.0%
Tax rate T25%
Cost of equity (CAPM)
Risk-free rate r_f4.0%
Equity beta β1.10x
Equity risk premium ERP5.0%
Equity costs 9.50% (=4.0% + 1.10x × 5.0%), debt costs 4.50% after the 25% shield. Blended at 40/60 they give a WACC of 7.50%.
Try this

Shift weight toward debt and WACC usually falls, because shielded debt is cheaper than equity. Raising the tax rate deepens the shield and lowers the after-tax cost of debt.

Note: only debt carries the (1 − T) tax shield, since interest is tax-deductible and dividends are not. The weights w_d and w_e should be market values of debt and equity, not book values, because WACC is the return the market requires today.

Reflect: if cheap shielded debt always lowers WACC, why not finance the firm almost entirely with debt? What does this model leave out about how k_d and k_e respond as leverage climbs?

Why it matters

The weights answer a simple question. Of every dollar funding the business, how much comes from lenders and how much from owners, valued the way the market values them now. Use the dusty book numbers and you can conclude debt and equity matter equally when the market says equity is worth twice as much. That error feeds straight into the WACC and can flip an investment decision. Where a leveraged buyout or restructuring is coming, the future weights matter more than today’s.

Formulas

Market-value weights
wd=DD+P+E,wp=PD+P+E,we=ED+P+Ew_d = \dfrac{D}{D + P + E}, \quad w_p = \dfrac{P}{D + P + E}, \quad w_e = \dfrac{E}{D + P + E}
Here D,P,ED, P, E are the market values of interest-bearing debt, preferred and common equity. The three weights sum to one. Market values are used throughout.

Worked examples

Scenario

Consider Company XYZ. Book values are US$100 million of debt and US$100 million of equity, a 50/50 book split. In the market the debt trades at 80 percent of face, so US$80 million, while the equity has doubled to US$200 million. Find the market-value weights and contrast them with the book weights.

Solution

Total market value is US$80 million plus US$200 million, which is US$280 million. The debt weight is 80 over 280, about 29 percent, and the equity weight is 200 over 280, about 71 percent. Book weights would say debt and equity each matter 50 percent, but the market says equity is more than twice as important as debt. A project that looks acceptable under book-value WACC can fail under the correct market-value WACC.

Common mistakes

  • ✗Book-value weights are fine because they come from the audited balance sheet. They reflect historical cost, not current value, and can sharply misstate the true financing mix, as the XYZ example shows.
  • ✗Weights should always be the current structure. If a change is planned, such as in a leveraged buyout, target weights that reflect the future mix are more appropriate.
  • ✗Only the debt-to-equity split matters. When a firm has preferred stock, it is a third weighted source, since it is money raised at a cost, with no free lunch.
  • ✗Market and book weights give similar answers. They can diverge widely once a stock has re-rated or debt trades away from par, which is exactly when the choice matters most.

Revision bullets

  • •Weights are each source’s share of total invested capital
  • •Use market values, not book values, since they show importance today
  • •Book weights freeze the past and can misstate the financing mix
  • •Use target weights when the capital structure is set to change
  • •Preferred stock is a third weighted source when present
  • •XYZ check: book 50/50 becomes market 29/71 once debt and equity re-price

Quick check

A firm’s debt has a market value of US$60 million and its equity a market value of US$140 million, with no preferred stock. The market-value weight of equity is

A firm is about to undergo a leveraged buyout that lifts debt from 40 percent to 80 percent of capital. Which weights should the WACC use?

Connected topics

WACCCost of Equity (CAPM)Cost of DebtLevered BetaAPV

Sources

  1. Titman & Martin
    Titman, S. & Martin, J. D. Valuation: The Art and Science of Corporate Investment Decisions. Pearson.
    Chapter on evaluating capital structure weights. The market-versus-book argument and target weights follow this text, illustrated with the Company XYZ example.
  2. Fernández (2011)
    Fernández, P. WACC: Definition, Misconceptions and Errors. IESE Business School Working Paper, 2011.
    Argues for consistent market-value weighting and flags book-value weighting as a recurring WACC error.
How to cite this page
Dr. Phil's Quant Lab. (2026). Capital Structure Weights. Derivatives Atlas. https://phucnguyenvan.com/concept/sabv-capital-structure-weights
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