330  Estimating the Cost of Capital fer from market value. Therefore, use a data service to determine market value when possible. In the case of debt equivalents, the valuation method will depend on the account. We discuss the valuation of debt and debt equivalents next. Market prices for U.S. corporate debt are reported on the Financial Indus- try Regulatory Authority (FINRA) TRACE system. As previously shown in Ex- hibit 15.9, Costco’s 2027 bond traded at $106.8, or 106.8 percent of par value, on August 30, 2019. To determine the market value of the bond, multiply 106.8 percent by the bond’s book value of $1 billion (found in the Costco annual report); the result is $1.068 billion. Since a bond’s price depends on the bond’s coupon rate versus its yield, not every Costco bond trades at the same price. For instance, the Costco bond maturing in 2024 closed at 104.0 percent of par on the same day. Consequently, each debt security needs to be valued separately. If an observable market value is not readily available, value debt securities at book value (referred to as carrying value), or use discounted cash flow. In most cases, the book value reported on the balance sheet reasonably approxi- mates the current market value. This will not be the case, however, if interest rates have changed since the company’s last valuation or if the company has entered into financial distress. In these two situations, the current price will differ from carrying value because either expected cash flows have changed or the discount rate has changed from its last valuation.28 In these situations, value each bond separately by discounting promised cash flows at the appropriate yield to maturity. The size and timing of coupons will be disclosed in the notes of a company’s annual report. Determine the appropriate yield to maturity by examining the yields from comparably rated debt with similar maturities. Next, value debt equivalents, such as operating leases and unfunded re- tirement obligations. In Chapters 22 and 23, we describe in detail the account- ing for operating leases and pensions, including the required adjustments to free cash flow and cost of capital. Consistency between free cash flow and the cost of capital is paramount. Starting in December 2019, the value of operat- ing leases is to be presented directly on the balance sheet; estimation is no longer necessary. To find the value of unfunded retirement obligations, search the pension note for the most recent market value. Although accounting au- thorities require disclosure of unfunded retirement obligations on the balance sheet, it is often embedded in other accounts. Equity  If the company’s common stock is publicly traded, multiply the market price by the number of shares outstanding. The market value of eq- uity should be based on shares outstanding in the capital market. Do not use shares issued, as they may include shares repurchased by the company but not retired. For European companies in particular, you need to be careful in 28 For floating-rate bonds, changes in Treasury rates won’t affect value, since coupons float with Treas- ury yields. Changes in market-based default premiums, however, will affect the market value of float- ing-rate bonds, since bonds are priced at a fixed spread above Treasury yields. Forecasting Target Capital Structure to Weight WACC Components  331 determining the correct amount of shares outstanding because of the way companies sometimes account for treasury shares. At this point, you may be wondering why you are valuing the company if you are going to rely on the market’s value of equity in the cost of capital. Shouldn’t you be using the estimated equity value? No. Remember, you are only estimating today’s market value to frame management’s philosophy concerning capital structure. To value the company, use forward-looking target weights. For privately held companies, the equity value is unobservable. In this case, you must determine equity value (for the cost of capital) either using a multiples approach or through DCF iteratively. To perform an iterative valu- ation, assume a reasonable capital structure, and value the enterprise using DCF. Using the estimate of debt-to-enterprise value, repeat the valuation. Continue this process until the valuation no longer materially changes. Capital Structure of Peer Companies To place the company’s current capital structure in the proper context, com- pare its capital structure with those of similar companies. Exhibit 15.11 pres- ents the median debt-to-value levels for ten industries. As the exhibit shows, high-growth industries like software and IT services, especially those with intangible investments, tend to use very little debt. In fact, many companies hold more excess cash than debt, causing the net debt ratio to be negative.29 EXHIBIT 15.11  Median Debt to Value by Industry, 2018 % Household products IT services Machinery Tobacco Personal products Biotechnology Software –7.0 –1.7 3.1 12.1 14.3 17.3 20.7 24.2 26.6 30.6 Hotels, restaurants, and leisure Paper and forest products Water utilities Note: Calculated using S&P 1500 classified by GICS industry. Market values used when available. 29 Over the past 15 years, cash balances have grown substantially because companies must pay taxes in their home country on any repatriated earnings. For companies whose home country’s tax rate is relatively high, cash will become trapped abroad. Following the change in U.S. tax code in 2017, the cash balance at American companies is expected to drop as companies repatriate foreign earnings at new, lower tax rates.