The target (optimal) capital structure is simply defined as the mix of debt, preferred stock and common equity that will optimize the company's stock price. As a company raises new capital it will focus on maintaining this target (optimal) capital structure.
It is important to note is that while the target structure is the capital structure that will optimize the company\'s stock price, it is also the capital structure that minimizes the company\'s weighted-average cost of capital (WACC).
Calculating Weighted Average Cost of Capital
A company's weighted average cost of capital (WACC) is calculated as follows:
WACC = (wd) [kd (1-t)] + (wps)(kps) + (wce)(kce)
Wd = weight percentage of debt in company's capital structure Wps = weight percentage of preferred stock in company's capital structure Wce = weight percentage of common stock in company's capital structure
As discussed previously, the weights of debt, preferred securities and common equity are based on the company's target (optimal) capital structure.
One thing to note is that the weights should be based on the market value of the firm\'s securities, unless the firm\'s book value shown on the balance sheet is similar to the market value.
For Newco, assume the following weights: wd = 40%, wps = 5% and wce = 55%. Compute Newco's weighted average cost of capital using the costs calculated in the examples above. For the purposes of this example, assume new equity comes from retained earnings and the discounted cash flow approach is used to derive kce.
WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce)
WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.12)
WACC = 0.084, or 8.4%
Taking the example further, suppose new equity needs to come from newly issued common stock; the WACC would then be calculated using a kc of 12.3%. Thus our WACC would be as follows: