You need the value of debt and equity to arrive at WACC. This ratio of debt and equity gives you the weights of debt and equity to arrive at WACC. In many cases, the company may have a temporary debt and equity structure. An example is a leveraged buy-out – where excessive amounts of debt is loaded for the LBO transaction. This level of debt is not sustainable and so the company pares down the debt quickly. How do you estimate the “normal” level of debt the company will work towards so you can arrive at the appropriate discount rate?
The target debt ratio is the debt ratio that you assume the firms will move towards over time from the current mix of debt and equity. The target debt ratio is estimated by estimating your industry’s average debt ratio OR computing the optimal debt ratio.
The average debt ratio of your industry is considered the target debt ratio because we assume that industry participants have picked the most appropriate level of debt given the risks inherent in your industry. (wisdom of the crowds)
The optimal debt ratio is considered the target debt ratio because this is the debt level that provides the highest valuation of your firm. We assume that the key objective of management is to maximize the firm’s value and therefore all managements will strive to move to this debt to equity mix from where they are at today to maximize the firm’s value. Theoretically, both the options should lead to the same debt ratios!
