thefirmwillprobablyincreaseovertimetowardtheindustry
average.
Target Debt Ratios and Changing Financing Mix
Mature firms sometimes decide to change their financing
strategies, pushing toward target debtratios thatare much
higheror lower than currentlevels. Whenanalyzing these
firms,weshouldconsidertheexpectedchangesasthefirm
moves from the current to the target debt ratio.
As ageneral rule,weshouldview thecostof capitalasa
year-specificnumber,and changetheinputseachyear.Not
onlywilltheweightsattachedtodebtandequitychangeover
time,butsowilltheestimatesofbetaandthecostofdebt.In
fact,oneoftheadvantagesofusingbottom-upbetasisthat
the beta each year can be estimated as a function of the
expected debt-to-equity ratio that year.
ILLUSTRATION 2.8: Estimating Cost of Capital: Disney,
Kristin Kandy, and Embraer
Culminatingtheanalysisinthischapter,weusethecostsof
equityanddebtcomputedforeachofthesefirmsearlierinthe
chapter to compute costs of capital.
Disney: In making these estimates, we begin with the
unlevered betas that we obtained for the divisions in
Illustration2.2andDisney’scostofdebtfromIllustration2.5.
Wealsoassumethatallofthedivisionsarefundedwiththe
samemix of debtand equity as theparent company. The
followingtableprovidesestimatesofthecostsofcapitalfor
the divisions: