Question

A firm's capital structure and its target capital structure proportions are important determinants of a firm's weighted average cost of capital. Use an real company to Explain. I recommend you use a listed company like eBay, Facebook or what ever you like to respond this question.

Answer 1

A company’s 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.

In determining the weights to be used in the WACC computation for a company, ideally, a manager should 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 = Market Value of Debt/(Market value of Debt + Market Value of Prefered Stock + Market Value of Equity)

We = Market Value of Equity/(Market value of Debt + Market Value of Prefered Stock + Market Value of Equity)

W_p = Market Value of Prefered Stock/(Market value of Debt + Market Value of Prefered Stock + Market Value of Equity)

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.

Company TCS and Infosys should also use the capital target structure to average the working average cost of capital.