#cfa-level-1 #corporate-finance #reading-36-cost-of-capital
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
| Bonds outstanding | $5 million |
| Preferred stock | 1 million |
| Common stock | 14 million |
| Total capital | $20 million |
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.
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2.2. Weights of the Weighted Averageod 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.
<span>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
Bonds outstanding $5 million Preferred stock 1 million Common stock 14 million Total capital $20 million
the weights that we apply would be
w d = 0.25 w p = 0.05 w e = 0.70
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.
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