Target Capital Structure and WACC

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

Market Value and  Book Value

Equity and debt market value is used to establish the ideal capital structure. Company capital structure targets, on the other hand, frequently utilize book value instead for the following reasons:

• Market values can change dramatically, but they rarely impact the optimum level of borrowing.
• The amount and types of capital a company invests, not the company itself, are of main significance to management.
• The capital structure policy ensures that management can borrow quickly and cheaply. Lenders and rating agencies use debt book values and equity in their calculation measures.

Target Weights and WACC

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

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

\(w_p\), 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 consistent with this target, then the target capital structure should be used.

Estimating Target Capital Structure Weights

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 a company’s capital structure or statements its management makes regarding capital structure policy. This will be useful in the inference of the target capital structure.
• Use the averages of comparable capital structures of companies as the target capital structure.

An example will help to explain this concept further.

Example: Calculating the Capital Structure

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

Pecking Order Theory

Managers have more information about a company’s performance and prospects—including future investment opportunities—than outsiders, resulting in asymmetric information— unequal distribution of information.

Since there is a greater potential for conflicts of interest, debt and equity capital providers demand higher returns from companies with increased asymmetry in information. In other words, investors know that management has access to more information about the business and will use this information when raising capital.

Companies will avoid equity financing for retained earnings or issuing debt. The pecking order theory suggests that managers prefer financing from internally generated funds, then debt, and finally equity. Additionally, managers will tend to issue equity if they believe their stock is overvalued.

Agency Costs

Internal costs incurred due to competing interests of shareholders (principals) and the management team are agency costs (agents). Items such as subsidized dinners, a corporate jet fleet, and chauffeured limousines are examples of “perquisite consumption” that executives might lawfully authorize for themselves at a cost to shareholders.

The costs arising from this conflict of interest have been called the agency costs of equity. Certain actions are taken to mitigate this risk. Such actions include requiring audited financial statements, holding an annual meeting, and using non-compete employment contracts and insurance to guarantee performance.

Agency theory predicts that a reduction in agency costs of equity results from an increase in the use of debt. The more financially leveraged a company is, the less room management has to take on more debt or spend money foolishly.

Question

Assume that the current market value of company XYZ’s debt and common equity are $55 million and $45 million, respectively, representing the company’s target capital structure. What are company XYZ’s target capital structure weights?

1. 55% debt; 45% equity.
2. 45% debt; 55% equity.
3. 50% debt; 50% equity.

Solution:

The correct answer is A.

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

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