Hey Hope all is well and safe!
my question regards the Target Capital Structure and how to get the correct D/E ratio when using the pure-play method.
when the explicit target weights are told i use them, if this information isn’t available, I choose one of the below methods:
- Assume that a company’s current capital structure, at current market value weights for each capital component, is equivalent to the company’s target capital structure;
- Examine trends in a company’s capital structure or statements made by its management relating to capital structure policy to infer the target capital structure; and
- Use the averages of comparable companies’ capital structures as the target capital structure.
however, the following is from a CFA question: DEF currently has a debt-to-equity ratio of 0.6. The new product line would be financed with $50 million of debt and $100 million of equity.
the correct answer: using DEF’s debt-to-equity ratio of 0.6 is not appropriate, but rather the debt-to-equity ratio of the new product, 0.5, is appropriate to use in calculating the new product line’s equity beta.
i thought that .6 was the correct answer as i assumed that the company’s current capital structure, is equivalent to the company’s target capital structure.
if anyone could please explain why i was wrong it would be greatly appreciated.