To calculate economic profit, we deduct a capital cost from operating profit. Why do we use market value of debt and equity to calculate WACC, but then use the book value to calculate $WACC. This seems inconsistent.
I don’t understand why book value is used at all. The $WACC is an opportunity cost and book value is somewhat arbitrary. If the company has gone through M&A the book value will be higher compared to organic growth.
What is not arbitrary is market value, so why not use it?
Another perspective. If the company’s market value is 100bn and WACC is 10%, shouldn’t we demand that the CEO generates at least 10bn (=100*10%). Anything above 10bn is economic profit? The difference between book and market value is often very large.
whatever happens in your income statement is a result of the balance sheet and a few items in balance sheet are a result of your income statement.
the reason its called economic profit is to see whether the firm has added value over the funds raised. Since the market is not arbitrary and is assumed to price a company’s assets more accurately, the WACC which is based on these market measures can be a suitable measure to even price BV of capital which forms the “capital charge”.
Cost of equity capital is an opportunity cost. No link to the balance sheet.
Okay, I get that it is about raising value over the funds raised. I see some value i that measure. Still the company that does a lot of acquisitions gets a lot of goodwill and has to pay goodwill*WACC in capital charge. This is on top of all other assets of the acquired company that are written up from book to market value. A competitor that grows organically does not have any such charges, despite the assets being exactly the same in reality. I think this is a massive problem.
I do understand how EVA is calculated, but is there something wrong with an alternative measure that would be calculated using WACC*market value? Want to know if I doing some illogical mistake in reasoning ths way.
It all boils down to the following - EVA is a measure,defined in a certain way, in order to measure return of capital in excess of opportunity costs. You are free to calculate WACC * MV of debt and capital, but it just won’t be the measure EVA. It’s like asking why ROE is calculated based on book value of equity in t0. It’s just how that specific useful ratio is defined. Some investors may use average equity also (so it’s rather important to be sure how analysed ratios are defined before trying to interpret their meaning).
No one is stopping anyone from calculating and using other ratios, if they think they enable making better investment decisions…