Read more on market value weights

While we can present pragmatic arguments for using market value - that market value weights will always be positive whereas book equity can turn negative or that the costs of equity and debt represent current costs and the values used for each should be a current market value as well - the real reason is a little deeper. Every discounted cashflow valuation is ultimately a hypothetical acquisition valuation, where we buy all of the debt and the equity in the firm and acquire the business. Since we have to pay market values when we buy debt and equity, we should market values to compute the weights.

The use of market value weights to compute cost of capital does create a problem of circular reasoning. The cost of capital, after all, is used to estimate the values of debt and equity that will generally be different from the market value weights used in the first place. If we use the hypothetical acquisition argument, this is not a problem. We will buy at the prevailing market values of debt and equity, even though our estimated values are different. If we want to restore consistency to the valuation, we can use our estimated values of debt and equity to compute the cost of capital and iterate to a solution. This is a good idea when valuing private businesses or initial public offerings, where there is no market value to begin with.