Why does WACC calculation become circular when using market value weights, and how do I solve it?

The circularity arises because WACC depends on the market value of equity, which depends on the DCF valuation, which depends on WACC. This is a real problem in practice, and there are several approaches to resolve it.

The Circular Logic:

1. WACC = (E/V) x Re + (D/V) x Rd(1-T)
2. E (equity value) = PV of FCFF discounted at WACC
3. V = E + D
4. But E depends on WACC, which depends on E/V... circle.

Solution 1: Iterative Approach (Most Common)

Start with a guess for E, compute WACC, run the DCF to get a new E, update WACC, repeat until the assumed E equals the computed E.

Solution 2: Target Capital Structure

Use the company's stated target D/E ratio (or industry average) instead of current market values. This breaks the circularity because the weights are fixed upfront. The CFA curriculum often favors this approach.

Solution 3: Excel Solver / Circular References

In practice, analysts enable circular references in Excel and let the spreadsheet iterate automatically. Set Excel to iterative calculation mode (File > Options > Formulas > Enable iterative calculation).

Example — Dunmore Engineering (fictional):

• Target D/V = 35%, E/V = 65%
• Cost of equity = 11%, After-tax cost of debt = 4%
• WACC = 0.65 x 11% + 0.35 x 4% = 8.55%

Using target weights avoids the circularity entirely.

Exam Tip: The CFA exam typically provides target capital structure weights to avoid the circularity issue. But understand that the circular problem exists and know the iterative solution conceptually.

Practice WACC calculations in our CFA Level II bank.