Target capital

What Is Target Capital?

Target capital is a measure or target within Corporate Finance and capital structure theory, referring to the optimal mix of funding sources a company aims to achieve to maximize Shareholder Value and minimize the overall cost of capital. In essence, it represents the desired proportion of Debt, Equity, and sometimes Preferred Stock that a company uses to finance its assets and operations¹⁴, ¹⁵, ¹⁶. This ideal structure balances various factors including the cost of borrowing, the market's perception of risk, and the company's operational requirements.

History and Origin

The concept of optimal capital structure, which underpins the idea of target capital, has evolved significantly over decades. Early financial theory often suggested that there was an ideal mix of debt and equity that could minimize a company's Weighted Average Cost of Capital (WACC) and thereby maximize its value. Landmark contributions, such as the Modigliani-Miller theorem in the late 1950s, initially argued that in a world without taxes or bankruptcy costs, a firm's value was independent of its capital structure. However, subsequent developments introduced real-world factors like taxes, financial distress costs, and agency costs, leading to the understanding that a specific target or optimal capital structure could indeed exist for a company¹³.

Beyond corporate finance, the idea of "target capital" also appears in financial regulation, particularly for institutions like banks and broker-dealers, where it refers to minimum capital levels they must maintain. For instance, in the United States, bank capital requirements have a long history, dating back to the mid-1800s, with evolving standards aimed at ensuring financial stability. The Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991, for example, introduced "prompt corrective action" to encourage banks to build capital before it became too low. Regulators, including the Federal Reserve, have continued to refine these frameworks, notably through international accords like Basel III, which aims to strengthen the regulation, supervision, and risk management of the banking sector globally.¹¹, ¹² The U.S. Securities and Exchange Commission (SEC) also maintains its "Net Capital Rule" for broker-dealers, requiring them to hold sufficient liquid resources.¹⁰

Key Takeaways

• Target capital represents the ideal mix of debt, equity, and preferred stock a company aims to achieve.
• The primary goal of establishing target capital is to optimize a company's stock price and minimize its overall cost of financing.
• Factors influencing target capital include the cost of funds, business risk, availability of funds, and market conditions.
• Regulatory bodies often set minimum capital requirements for financial institutions, influencing their target capital levels to ensure stability.
• Achieving target capital helps companies manage Financial Risk and supports strategic Investment Decisions.

Formula and Calculation

While there isn't a single universal "target capital" formula, the concept is most often applied in the context of a company's Capital Structure, specifically when determining the weights of its components for calculating the Weighted Average Cost of Capital (WACC). The WACC formula often uses target capital structure weights if a company is actively working to maintain a specific mix of financing.

The target weights for debt ($w_d$), equity ($w_e$), and preferred stock ($w_p$) are typically expressed as proportions of the total capital.