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.
Weighted Average Cost of Capital
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
A company's weighted average cost of capital (WACC) is calculated as follows:
WACC = (wd) [kd (1-t)] + (wps)(kps) + (wce)(kce)
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.the weights should be based on the market value of the firm's securities.
For Newco, assume the following weights: wd = 40%, wps = 5% and wce = 55%. Cost of debt( kd)=7% Tax=40% Cost of preferred stock (kps)=2.1% Cost of common stock 12%