Lesson 2 of 13
From the perspective of an investment analyst, the weights used in the calculation of WACC should be calculated on the basis of target capital structure that the firm expects to achieve. However, since it’s difficult to find out the company’s target capital structure, the analysts will use the current capital structure of the company as a proxy for their target capital structure. In doing so, they will current capital structure based on the market values of each component.
Let’s say the market values of a firm’s capital are: Debt outstanding – $4 million, Preferred - $1 million, and Equity - $5 million.
Total capital is $10 million.
With this information we can calculate the weight of each component
Wd = 4/10 = 0.40
Wp = 1/10 = 0.10
We = 5/10 = 0.50
The analyst may also use any other information available to him while determining the weights. For example, if he notices that the firm has been consistently issuing more debt year after year, he may use a higher weight for the debt component. He the analyst believes that the firm’s current capital structure is not a good indicator of its target capital structure then he can also use the average capital structure of the industry.