The target (optimal) capital structure is simply defined as the mix of debt, preferred stock and common equity that will optimize the company's stock price. As a company raises new capital it will focus on maintaining this target (optimal) capital structure.

Look Out!
It is important to note is that while the target structure is the capital structure that will optimize the company\'s stock price, it is also the capital structure that minimizes the company\'s weighted-average cost of capital (WACC).

Calculating Weighted Average Cost of Capital
A company's weighted average cost of capital (WACC) is calculated as follows:

Formula 11.8

WACC = (wd) [kd (1-t)] + (wps)(kps) + (wce)(kce)

Where:
Wd = weight percentage of debt in company's capital structure
Wps = weight percentage of preferred stock in company's capital structure
Wce = weight percentage of common stock in company's capital structure

As discussed previously, the weights of debt, preferred securities and common equity are based on the company's target (optimal) capital structure.

Look Out!
One thing to note is that the weights should be based on the market value of the firm\'s securities, unless the firm\'s book value shown on the balance sheet is similar to the market value.

Example: WACC
For Newco, assume the following weights: wd = 40%, wps = 5% and wce = 55%. Compute Newco's weighted average cost of capital using the costs calculated in the examples above. For the purposes of this example, assume new equity comes from retained earnings and the discounted cash flow approach is used to derive kce.

Answer:
WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce)
WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.12)
WACC = 0.084, or 8.4%

Taking the example further, suppose new equity needs to come from newly issued common stock; the WACC would then be calculated using a kc of 12.3%. Thus our WACC would be as follows:

WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce)
WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.123)
WACC = 0.086 or 8.6%

For more on the WACC, including its components and importance, check out the following article: Investors Need A Good WACC.



Marginal Cost of Capital

Related Articles
  1. Investing

    Investors Need A Good WACC

    Weighted average cost of capital may be hard to calculate, but it's a solid way to measure investment quality.
  2. Investing

    Breaking Down Optimal Capital Structure

    An optimal capital structure shows the best balance of debt to equity a company can have in order to minimize its cost of capital.
  3. Investing

    DCF Valuation: The Stock Market Sanity Check

    Calculate whether the market is paying too much for a particular stock.
  4. Small Business

    Capital Structure

    Capital structure is the combination of the debt and equity a company uses to finance its long-term operations and growth.
  5. Investing

    IBM Stock: Capital Structure Analysis

    Learn about IBM's capital structure and why its market debt-to-equity ratio is lower than the rest of the industry, even though its market capitalization declined.
  6. Investing

    Home Depot's 6 Key Financial Ratios (HD)

    Learn about important financial ratios used to determine the performance of retailer Home Depot; these give a quick snapshot of the company's profitability.
  7. Investing

    Yahoo Stock: Capital Structure Analysis (YHOO)

    Learn about Yahoo's capital structure, including whether or not a decline in year-over-year earnings is leading the company to use more debt.
  8. Financial Advisor

    Structured Notes: What You Need to Know

    Structured notes are complex, high risk and might not be suitable for individual investors. Here's why.
  9. Investing

    UPS Stock: Capital Structure Analysis

    Analyze UPS' capital structure to determine the relative importance of debt and equity financing. Identify the factors influencing financial leverage trends.
Frequently Asked Questions
  1. What is the difference between yield and return?

    While both terms are often used to describe the performance of an investment, yield and return are not one and the same ...
  2. What are the Differences Among a Real Estate Agent, a broker and a Realtor?

    Learn how agents, realtors, and brokers are often considered the same, but in reality, these real estate positions have different ...
  3. What is the difference between amortization and depreciation?

    Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally ...
  4. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ...
Trading Center