Question

Describe the relationship between firm's target capital structure and WACC.

Answer 1

Firm's target capital structure refers to capital which the firm is trying to obtain. target capital structure describes the mix of debt, preferred stock and common equity which is 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.

Weighted average cost of capital (WACC) is the average rate of return a company expects to compensate all its different investors. The weights are the fraction of each financing source in the company's target capital structure.

There is a direct relationship between the Firm's target capital structure and WACC, other relationship is that we use target Capital Structure to Estimate the Weighted Average Cost of Capital (WACC). In determining the weights to be used in the WACC computation for a firm, A manager should use the proportion of each source of capital which will be used.

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

W_d, the proportion of debt = MV of Debt / MV of debt + MV of Equity +MV of Pref. stock

W_e, the proportion of debt = MV of Equity / MV of debt + MV of Equity +MV of Pref. stock

W_p, the proportion of debt = MV of Pref. stoc00k / MV of debt + MV of Equity +MV of Pref. stock

If however 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.

Now it depends on how are our capital is raised through debt, equity and pref. stock

for example there can be possibility of two different capital structure like

	Structure 1	Structure 2
Equity	5000	3000
Debt	3000	4000
Pref. Stock	2000	3000
Total	10000	10000

Let assume the Cost of debt is 10%, Cost of equity is 15% and Cost of pref. stock is 12 %

If we calculate WACC

in structure 1 WACC is - 12.9%

in structure 2 WACC is - 12.1%

So, WACC depends on how has firm's target capital structure and how firm has raised it, we can see the direct relationship between these two.