Productivity at your daily life

As we shall see in Chapter 13, each firm has an optimal capital structure, defined as that mix of debt, preferred, and common equity that causes its stock price to be maximized. Therefore, a value-maximizing firm will establish a target (optimal) capital structure and then raise new capital in a manner that will keep the actual capital structure on target over time. In this chapter, we assume that the firm has identified its optimal capital structure, that it uses this optimum as the target, and that it finances so as to remain constantly on target. How the target is established will be examined in Chapter 13.

The target proportions of debt, preferred stock, and common equity, along with the component costs of capital, are used to calculate the firm’s WACC. To illustrate, suppose NCC has a target capital structure calling for 30 percent debt, 10 percent preferred stock, and 60 percent common equity. Its before-tax cost of debt, rd, is 11 percent; its after-tax cost of debt is rd(1
T)  11%(0.6)  6.6%; its cost of preferredstock, rps, is 10.3 percent; its cost of common equity, rs, is 14.5 percent; its marginal tax rate is 40 percent; and all of its new equity will come from retained earnings.Every dollar of new capital that NCC obtains will on average consist of 30 cents of debt with an after-tax cost of 6.6 percent, 10 cents of preferred stock with a cost of
10.3 percent, and 60 cents of common equity with a cost of 14.5 percent. The average cost of each whole dollar, the WACC, is 11.7 percent.
Two points should be noted. First, the WACC is the weighted average cost of each new, or marginal, dollar of capital—it is not the average cost of all dollars raised in the past. We are primarily interested in obtaining a cost of capital to use in discounting future cash flows, and for this purpose the cost of the new money that will be invested is the relevant cost. On average, each of these new dollars will consist of some debt,
some preferred, and some common equity.
Second, the percentages of each capital component, called weights, could be based on (1) accounting values as shown on the balance sheet (book values), (2) current market values of the capital components, or (3) management’s target capital structure, which is presumably an estimate of the firm’s optimal capital structure. The correct weights are those based on the firm’s target capital structure, since this is the best estimate of how the firm will, on average, raise money in the future. Recent survey evidence indicates
that the majority of firms do base their weights on target capital structures, and that the target structures reflect market values.

Taken From : Credit Repair by Attorneys Robin Leonard and Deanne Loonin

No related posts.

Related posts brought to you by Yet Another Related Posts Plugin.