The Capital Structure Weights

We will use the symbol E (for equity) to stand for the market value of the firm's equity. We calculate this by taking the number of shares outstanding and multiplying it by the price per share. Similarly, we will use the symbol D (for debt) to stand for the market value of the firm's debt. For long-term debt, we calculate this by multiplying the market price of a single bond by the number of bonds outstanding.

If there are multiple bond issues (as there normally would be), we repeat this calculation of D for each and then add up the results. If there is debt that is not publicly traded (because it is held by a life insurance company, for example), we must observe the yield on similar, publicly traded debt and then estimate the market value of the privately held debt using this yield as the discount rate. For short-term debt, the book (accounting) values and market values should be somewhat similar, so we might use the book values as estimates of the market values.

Finally, we will use the symbol V (for value) to stand for the combined market value of the debt and equity:

If we divide both sides by V, we can calculate the percentages of the total capital represented by the debt and equity:

These percentages can be interpreted just like portfolio weights, and they are often called the capital structure weights.

For example, if the total market value of a company's stock were calculated as $200 million and the total market value of the company's debt were calculated as $50 million, then the combined value would be $250 million. Of this total, E/V = $200 million/250 million = 80%, so 80 percent of the firm's financing would be equity and the remaining 20 percent would be debt.

We emphasize here that the correct way to proceed is to use the market values of the debt and equity. Under certain circumstances, such as when calculating figures for a privately owned company, it may not be possible to get reliable estimates of these quantities. In this case, we might go ahead and use the accounting values for debt and equity. Although this would probably be better than nothing, we would have to take the answer with a grain of salt.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VI. Cost of Capital and Long-Term Financial Policy

15. Cost of Capital

© The McGraw-Hill Companies, 2002

PART SIX Cost of Capital and Long-Term Financial Policy

To get a feel for actual, industry-level WACCs, visit . valuation.ibbotson.com.

weighted average cost of capital (WACC)

The weighted average of the cost of equity and the aftertax cost of debt.

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