2.2. Weights of the Weighted Average

How do we determine what weights to use? 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 company’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:

1. Assume the company’s current capital structure, at market value weights for the components, represents the company’s target capital structure.

2. Examine trends in the company’s capital structure or statements by management regarding capital structure policy to infer the target capital structure.

3. Use averages of comparable companies’ capital structures as the target capital structure.

In the absence of knowledge of a company’s target capital structure, we may take Method 1 as the baseline. Note that in applying Method 3, we use an unweighted, arithmetic average, as is often done for simplicity. An alternative is to calculate a weighted average, which would give more weight to larger companies.

Suppose we are using the company’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 proportions. For example, if a company has the following market values for its capital

the weights that we apply would be

Example 3 illustrates the estimation of weights. Note that a simple way of transforming a debt-to-equity ratio D/E into a weight—that is, D/(D + E)—is to divide D/E by 1 + D/E.