CFA CFA Level 2 WACC… HUH… WHAT IS IT GOOD FOR

# WACC… HUH… WHAT IS IT GOOD FOR

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This is probably more of a Level 1 question and is probably just a refresher for most of you, but in my readings I have come across the following type of question:

Firm XYZ has \$100 million of MV debt, \$300 million of MV equity, and target D/E ratio of .5. Also, they have required return on debt is 5%, required return on equity is 10%. Tax rate is 35%. What is the WACC?

And in each answer, I calculate the weightings of debt and equity based on the current MVs (in this case Wd = .25 and We = .75), but the answers want you to use the TARGET weightings (in this case Wd = .33 and We = .67).

I’m wondering what the rationale is for using target weights vs. current market rates? I’m just looking for an intuitive way to understand why analysts would want to use ideal targets instead of current values. Thanks for any input!

• rsparks
Participant
• CFA Level 2
4

It’s 3am here and Ive been up watching the football so this may not be correct.

i think u are take d/d+e to get your weights when it should be d/e to get .33 d and .667 e? 100/300?
looks like they are using the firm”s actual weight.

Firms are subject to market, financial and business risk, so you should always end up using the firm’s weight no matter what or leveraging betas of similar companies if you didn’t have the data. Even similar competitors though can have completely different capital structures: Walmart sells more grocery lines than target even though they are competitors.

Correct me if I’m wrong as I’m off to bed!

Ron

• policedog
Participant
• Undecided
4

Looked up WACC (again) and the definition uses market value, so it does seem like
.25 and .75 are the right ones.

• policedog
Participant
• Undecided
3

@rsparks no I think @ajost14 got it right. As to weights, I think there are uses for both target and actual WACC, I’m not sure if there is a standard thing where you have to use target (or actual values). Just like there is target D/E ratios and actual D/E ratios?

• rsparks
Participant
• CFA Level 2
1

Morning!

Seems i was wrong, but found why we use target instead of market value as ive quickly looked at reading 36, section 4 topics in cost of capital estimation in example 11. they used target weight for a privately owned company with weight of debt: d/d+e. in your example it would be .5/1.5 = .333 for debt.

This caused me to do more reading..again lol. I’ve also checked section 2 weights of weighted average and this is what they mention: if you have the target ratio, then this should be used. If you don’t, then we can estimate by using the market value.

Ideally, we want to use the proportion of each source of capital that the company would use in the project or company. If we assume that a company has a target capital structure and raises capital consistent with this target, we should use this target capital structure. The target capital structure is the capital structure that a company is striving to obtain. If we know the companyâ€™s target capital structure, then, of course, we should use this in our analysis. Someone outside the company, however, such as an analyst, typically does not know the target capital structure and must estimate it using one of several approaches:
Assume the companyâ€™s current capital structure, at market value weights for the components, represents the companyâ€™s target capital structure.
Examine trends in the companyâ€™s capital structure or statements by management regarding capital structure policy to infer the target capital structure.
Use averages of comparable companiesâ€™ capital structures as the target capital structure.
Suppose we are using the companyâ€™s current capital structure as a proxy for the target capital structure. In this case, we use the market value of the different capital sources in the calculation of these .

a simple way of transforming a debt-to-equity ratio D/E into a weightâ€”that is, D/(D + E)â€”is to divide D/E by 1 + D/E.

hoped this help as I’m on my phone and public transport.

• 1

That was helpful @rsparks thank you! That makes sense, as with future projects you would want to use targets if you have them available.

• WesMantooth
Participant
• CFA Charterholder
0

WACC is used often in capital budgeting where the underlying purpose is to estimate a value based on future cash flows. Future estimate being the key. It makes logical sense to use inputs in these calculations that are derived from future estimates. So the target capital structure (aka estimate of future firm structure assuming the company is successful in moving towards it) is used for the same reason that if I was looking for the selling price to use in my Revenue estimate, I wouldn’t use the current spot price, I would use some estimate based on a forward curve.