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If the firm has preferred stock in its capital structure, the weight of preferred equity is calculated
with preferred equity as the numerator:
The values for a company‟s long-term debt and owners‟ equity can be found on its balance sheet,
called book values, but we would prefer not to use them when calculating the relative weights of debt
and equity capital. The reason for this preference is that the balance sheet captures and reports
historical information about the financial position of the firm. The values shown on the balance sheet
for long-term debt reflect the amount received when the debt was originally issued at some past date,
less any amortized discount if the debt was issued for less than face value, or less any amortized
premium if the debt was issued for more than face value.
The values shown on the balance sheet for common equity are the sum of the contributed capital
received when the firm originally issued shares of common stock, plus any earnings from past
operations retained in the firm, less any shares of common stock repurchased by the firm (called
treasury stock). And if the firm has any shares of preferred stock outstanding, the values shown on the
balance sheet for preferred equity are the amounts received when the preferred shares were originally
issued, less any shares of preferred stock repurchased by the firm. These amounts are all based on
events that occurred in the past.
Firms calculate their current cost of capital to determine their current hurdle rate for internal
investment projects. Calculating the relative weights of debt and common and preferred equity in the
capital structure using balance sheet book values, therefore, may not produce the current cost of
capital. To do this, we instead want to calculate current weights of debt and equity in the firm‟s capital
structure using current values, also called market values. The market value of common equity for any
firm is the total current value of its shares of stock traded in the financial markets and is calculated as
the current price per common share times the number of common shares currently outstanding, which
is frequently called market capitalization, or “market cap” by the financial press. The market value for
preferred equity, if the firm has any outstanding, is calculated in the same manner: the current price
per share of preferred stock times the number of preferred shares outstanding.
Ideally, the market value of debt for a firm is calculated in the same manner, multiplying the current
price per bond times the number of bonds outstanding. Determining the firm‟s total market value of
debt, however, is quite difficult because many firms have many different debt issues. It is not unusual
for large corporations to have 10 or 20 (or more!) individual and unique bond issues, so to determine
the total market value of debt for a company it is necessary to calculate the market value of each
individual bond issue and then add up all the values to determine the total market value of debt.
Calculating market value of debt is also made more difficult by two facts: (1) publicly owned bonds
are traded infrequently compared to common stock, and their trades are not as widely reported, and (2)
many bonds are privately held by institutional investors and are not publicly traded at all, so current
prices for these bonds are not available.
The key point here is it is simple to determine market value of common and preferred equity;
multiply the current price per share by the number of shares currently outstanding. Determining
market value of debt is more troublesome, as the firm may have many different bond issues, and it can
be difficult or impossible to find the current bond price for these different bond issues.