328  Estimating the Cost of Capital must be accounted for. In an enterprise DCF using the WACC, the tax shield is valued as part of the cost of capital. To value the tax shield, reduce the cost of debt by the marginal tax rate: After-Tax Cost of Debt Cost of Debt = × − ( ) 1 Tm Chapters 10 and 11 detail how to calculate the marginal tax rate for histori- cal analysis. For use in the cost of capital, calculate the marginal tax rate in a consistent manner, with one potential modification. Multinational companies often borrow money in high-tax countries to lower their tax burden in those countries. Check the annual report for the location of corporate debt, and, if necessary, use the marginal tax rate where the debt was raised, not the statu- tory tax rate of the company’s home country. For companies with either low or volatile earnings, the statutory tax rate may overstate the marginal tax rate in future years. According to research by John Graham, the statutory marginal tax rate overstates the future marginal tax rate because of rules related to tax loss carryforwards, tax loss carrybacks, investment tax credits, and alternative minimum taxes.27 Graham uses simu- lation to estimate the realizable marginal tax rate on a company-by-company basis. Graham estimates that the marginal tax rate is on average five percent- age points below the statutory rate, primarily driven by smaller, less profit- able companies. Forecasting Target Capital Structure to Weight WACC Components With our estimates of the cost of equity and after-tax cost of debt in hand, it is now possible to blend the two expected returns to estimate the WACC. To do this, use the target weights of debt (net of excess cash) and equity to enterprise value (net of excess cash) on a market basis: WACC = − ( ) + D V k T E V k d m e 1 Using market values rather than book values to weight expected returns follows directly from the formula’s algebraic derivation (see Appendix B for a derivation of free cash flow and WACC). But consider a more intuitive ex- planation: the WACC represents the expected return on a different investment with identical risk. Rather than reinvest in the company, management could return capital to investors, who could reinvest elsewhere. To return capital without changing the capital structure, management can repay debt and 27 J. Graham and L. Mills, “Using Tax Return Data to Simulate Corporate Marginal Tax Rates,” Journal of Accounting and Economics 46 (2009): 366–388; and J. Graham, “Proxies for the Corporate Marginal Tax Rate,” Journal of Financial Economics 42 (1996): 187–221. Forecasting Target Capital Structure to Weight WACC Components  329 repurchase shares but must do so at their market value. Conversely, book value represents a sunk cost, so it is no longer relevant. The cost of capital should rely on a forecast of target weights, rather than current weights, because at any point a company’s current capital structure may not reflect the level expected to prevail over the life of the business. The current capital structure may merely reflect a short-term swing in the com- pany’s stock price, a swing that has yet to be rebalanced by management. Thus, using today’s capital structure may cause you to overestimate (or un- derestimate) the value of tax shields for companies whose leverage is expected to drop (or rise). Many companies are already near their target capital structure. If the com- pany you are valuing is not, decide how quickly the company will achieve the target. In the simplest scenario, the company will rebalance immediately and maintain the new capital structure. In this case, using the target weights and a constant WACC (for all future years) will lead to a reasonable valuation. If you expect the rebalancing to happen over a long period of time, then use a different cost of capital each year, reflecting the capital structure at the time. In practice, this procedure is complex; you must correctly model the weights, as well as the changes in the cost of debt and equity (because of increased default risk and higher betas). For extreme changes in capital structure, modeling en- terprise DCF using a constant WACC can lead to a substantially erroneous valuation. In this case, do not use WACC. Instead, value the company using adjusted present value. To estimate the target capital structure from an external perspective, first estimate the company’s current market-value-based capital structure. Next, review the capital structure of comparable companies. Finally, examine man- agement’s implicit or explicit approach to financing and its implications for the target capital structure. We discuss each step next. Current Capital Structure To determine the company’s current capital structure, measure the market value of all claims against enterprise value. For most companies, the claims will consist primarily of traditional debt and equity (this chapter’s final sec- tion addresses more complex securities). If a company’s debt and equity are publicly traded, simply multiply the quantity of each security by its most re- cent price. Most difficulties arise when securities are not traded and prices cannot be readily observed. Debt and Debt Equivalents, Net of Excess Cash  To value debt and debt equiv- alents, sum short-term debt, long-term debt, and debt equivalents like unfunded retirement obligations. From this total, subtract excess cash to determine net debt. Debt will be recorded on the balance sheet at book value, which may dif-