Answer 15

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See industry averages of debt ratios

Not only can the weights on debt and equity change, but so can the other components - cost of equity, cost of debt and tax rate. In fact, you should expect the cost of capital to change for most firms, and especially so for young firms or firms in transition. Generally, firms that are young and risky have high costs of equity and debt, little or no debt and high costs of capital. As you expect these firms to grow and mature over time, you would expect the costs of equity and debt to come down, the debt ratio to increase and the cost of capital to decline.

The practical question that you will face is in coming up with these target debt ratios and costs of funding. There are two solutions. One is to look at industry averages, especially the averages for mature firms in the business for all of these components. The other is to compute the optimal debt ratio (with all the components) for your firm.

In conventional practice, firms are often valued with a constant debt ratio and cost of capital over time. This is why there is much debate about whether one should use actual debt ratio weights or target weights, with many analysts arguing for the latter. Either extreme will be incorrect, with the former leading to too low a value for young and risky firms and the latter to too high a value (since you are assuming that the firm will do tomorrow what it cannot really do for another 5 or 10 years). The best compromise is to start with the actual debt ratio and move to your target debt ratio over time.




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