Question

Current Capital Structure and WACC

	Weight	Cost	Weighted Cost
Debt	10%	6.50%	0.65%
Preferred	15%	14%	2.10%
Equity	75%	18%	13.50%
Total	100%		16.25% WACC

Target Capital Structure and WACC

	Weight	Cost	Weighted Cost
Debt	40%	6.5%	2.6%
Preferred	10%	14%	1.40%
Equity	50%	18%	9%
Total	100%		13% WACC

What are some differences between these two structures? What issues could the target capital structure create?

Answer 1

Difference between current and target capital structures:

• While debt constitutes only 10% of total capital layout of the enterprise in the current structure, it is targeted at 40%. Also, it can be acknowledged that the cost of debt will not change with the increase in debt structure.
• Preferred stock is targeted to be decreased from 15 to 10% thus decreasing the weighted cost from 2.1 to 1.4%
• Equity is also targeted to be reduced from 75 to 50% which decreases the weighted cost of equity from 13.5 to 9%

From the above changes, following assertions can be made of the targeted scenario:

• The company is aiming to increase the weight of the debt in the total capital structure implying that weight average cost of capital of the firm will decrease resulting in benefits to the company.
• Though debt is always cheaper than equity, there is an obligation of interest payments attached to it which results in hardship to the company more often than not.
• There is no obligation on the board to pay off dividends regularly to the shareholders, therefore equity is always a better route to raise funds.
• The target capital structure has a weighted average cost of capital of 13% rather than current 16.25% due to increase in debt- equity ratio and debt - total capital ratio.
• The benefit of increase in debt can be reflected in the earnings due to cheaper financing up to a certain point then it falls down steeply as the company becomes over-leveraged due to excessive debt.