Can financing weights change over time

Using the current market values to obtain weights will yield a cost of capital for the current year. But can the weights attached to debt and equity, and the resulting cost of capital, change from year to year? Absolutely, and especially in the following scenarios:

• Young firms: Young firms often are all equity funded largely because they do not have the cash flows (or earnings) to sustain debt. As they become larger, increasing earnings and cashflow usually allow for more borrowing. When analyzing firms early in the life cycle, we should allow for the fact that the debt ratio of the firm will probably increase over time towards the industry average.

• Target Debt Ratios and Changing financing mix: Mature firms sometimes decide to change their financing strategies, pushing towards target debt ratios that are much higher or lower than current levels. When analyzing these firms, we should consider the expected changes as the firm moves from the current to the target debt ratio.

As a general rule, we should view the cost of capital as a year-specific number, and change the inputs each year. Not only will the weights attached to debt and equity change over time, but so will the estimates of beta and the cost of debt. In fact, one of the advantages of using bottom-up betas is that the beta each year can be estimated as a function of the expected debt to equity ratio that year.

Illustration 4.15: Market value and book value debt ratios: Disney and Aracruz

Disney has a number of debt issues on its books, with varying coupon rates and maturities. Table 4.15 summarizes Disney's outstanding debt:

Table 4.15: Debt at Disney: September 2003
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