###### NPV as a Capital Budgeting Evaluation ...

Projects which have a positive NPV should, in theory, increase the value of... **Read More**

The target capital structure of a company refers to the capital which the company is striving to obtain. In other words, target capital structure describes the mix of debt, preferred stock and common equity which is expected to optimize the stock price of a company. As a company raises new capital, it will focus on maintaining this target or optimal capital structure.

To determine the weights to be used in the computation of WACC of a company, a manager should ideally use the proportion of each source of capital which will be used.

For example, if a company has three sources of capital: debt, common equity, and preferred stock, then:

\(w_d\), the proportion of debt:

$$ w_d=\cfrac {\text{Market value of debt}}{\text{Market value of debt}+\text{Market value of equity}+\text{ Market value of preferred stock}} $$

\(w_e\), the proportion of equity:

$$ w_e =\cfrac {\text{Market value of equity}}{\text{Market value of debt}+\text{Market value of equity}+\text{ Market value of preffered stock}} $$

\(w_p\), the proportion of preferred stocks:

$$ w_p =\cfrac {\text{Market value of preferred stock}}{\text{Market value of debt}+\text{Market value of equity}+\text{ Market value of preferred stock}} $$

However, if the target capital structure is known and the company attempts to raise capital in a manner which is consistent with this target, then the target capital structure should be used.

An external analyst will most likely not know the target capital structure of a company, and will, therefore, have to estimate it using one of the following methods:

- assume that a company’s current capital structure, at current market value weights for each capital component, is equivalent to the company’s target capital structure;
- examine trends in the capital structure of a company or statements made by its management relation to capital structure policy to infer the target capital structure; and
- use the averages of comparable capital structures of companies as the target capital structure.

an example will help to explain this concept Further.

An analyst wishes to determine the proportion of debt and equity that Company ABC would use to estimate these proportions using (i) the current capital structure of Company ABC, and (ii) the average of company ABC’s competitors’ capital structure. The following information is given:

Company ABC market value of debt = $25 million

Company ABC market value of equity = $35 million

Company ABC’s competitors and their capital structures are:

$$ \begin{array}{c|c|c} \textbf{Competitor} & \textbf{Market Value of Debt} & \textbf{Market Value of Equity} \\ \hline \text{X} & {$20 \text{ million}} & {$40 \text{ million }} \\ \hline \text{Y} & {$32 \text{ million}} & {$55 \text{ million}} \\ \end{array} $$

**Solution to (i):**

\(w_d\), the proportion of company ABC debt =

$$ \cfrac{ $25 \text{ million}}{$25 \text{ million}+$35 \text{ million}}=0.41667 $$

\(w_e\), the proportion of company ABC equity =

$$ \cfrac{ $35 \text{ million}}{$25 \text{ million}+$35 \text{ million}}=0.58333 $$

**Solution to (ii):**

\(w_d\), the arithmetic average of company ABC’s competitors’ debt:

$$ \begin{align*} w_d = \cfrac { {\left( \cfrac{ $20 \text{ million}}{$20 \text{ million}+$40 \text{ million}} \right)}+{ \left( \cfrac{ $32 \text{ million}}{$32 \text{ million}+$55 \text{ million}} \right)} }{2} & =\cfrac {0.33333+0.36782}{2} \\ & =0.35057 \\ \end{align*} $$

\(w_e\), the arithmetic average of company ABC’s competitors’ equity:

$$ \begin{align*} w_e \cfrac { {\left( \cfrac{ $40 \text{ million}}{$20 \text{ million}+$40 \text{ million}} \right)}+{ \left( \cfrac{ $55 \text{ million}}{$32 \text{ million}+$55 \text{ million}} \right)} }{2} & =\cfrac {0.66667+0.63218}{2} \\ & =0.64943 \\ \end{align*} $$

Although in the above example, the arithmetic average is calculated, it is also possible to compute the weighted average which would give a greater weight to larger companies.

QuestionIf the current market value of company XYZ’s debt and common equity are $55 million and $45 million respectively and represents the company’s target capital structure, what is company XYZ’s target capital structure weights?

A. 55% debt; 45% equity

B. 45% debt; 55% equity

C. 50% debt; 50% equity

Solution:The correct answer is A.

$$ w_d = \cfrac{ $55 \text{ million}}{$55 \text{ million}+$45 \text{ million}}=0.55 $$

$$ w_e =\cfrac{ $45 \text{ million}}{$55 \text{ million}+$45 \text{ million}}=0.45 $$

*Reading 33 LOS 33c:*

*Describe the use of target capital structure in estimating WACC and how target capital structure weights may be determined*