Tuesday, October 18, 2011

Target Capital Structure

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

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).

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.

Example: WACC

For Newco, assume the following weights: wd = 40%, wps = 5% and wce = 55%. 
Cost of debt( kd)=7%
Cost of preferred stock (kps)=2.1%
Cost of common stock 12%

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%. so 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%

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