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

    Weighted Average Cost Of Capital (WACC)

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

    How to Calculate Required Rate of Return

    The required rate of return is used by investors and corporations to evaluate investments. Find out how to calculate it.
  3. Investing

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  4. 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.
  5. Markets

    Target Corp: WACC Analysis (TGT)

    Learn about the importance of capital structure when making investment decisions, and how Target's capital structure compares against the rest of the industry.
  6. Investing

    DCF Valuation: The Stock Market Sanity Check

    Calculate whether the market is paying too much for a particular stock.
  7. Markets

    Top Things To Know For An Investment Banking Interview

    Without some basic knowledge, you won't get the job. Find out what you need to know and how to prepare.
  8. Investing

    The Optimal Use Of Financial Leverage In A Corporate Capital Structure

    The amount of debt and equity that makes up a company's capital structure has many risk and return implications.
  9. Trading

    EVA: What Does It Really Mean?

    By David Harper, (Contributing Editor - Investopedia Advisor) Contact David As we performed a sequence of calculations to find Disney's (DIS) 2004 economic profit, we discovered that despite ...
  10. Markets

    Apple's $12 Billion Bond Issue Meant to Boost WACC

    Apple, Inc. announced that it would issue $12 billion in corporate bonds to the public in order to return profits to shareholders via dividends and a share buyback program of equivalent size.
Trading Center