332  Estimating the Cost of Capital Industries with heavy fixed investment in tangible assets, like mining and utilities, tend to have higher debt levels. In 2018, the median debt-to-value ratio for S&P 1500 nonfinancial companies was 17.6 percent, and the median debt-to-equity ratio was 21.4 percent. It is perfectly acceptable for a company’s capital structure to be different from that of its industry. But you should understand why. For instance, is the company philosophically more aggressive or innovative in the use of debt financing, or is the capital structure only a temporary deviation from a more conservative target? Often, companies finance acquisitions with debt they plan to retire quickly or refinance with a stock offering. Alternatively, is there anything different about the company’s cash flow or asset intensity that can explain the difference? Determine the cause for any difference before applying a target capital structure. Management’s Financing Philosophy As a final step, review management’s historical financing philosophy. Even better, question management outright, if possible. Has the current team been actively managing the company’s capital structure? Is the management team aggressive in its use of debt? Or is it overly conservative? Consider Garmin, the personal-technology company that makes GPS devices. Although cash flow is strong and stable, the company rarely issues debt. From a financing perspective, it doesn’t need to issue additional securities; investments can be funded with current profits. Estimating WACC for Complex Capital Structures The weighted average cost of capital is determined by weighting each secu- rity’s expected return by its proportional contribution to total value. For a complex security, such as convertible debt, measuring expected return is chal- lenging. Is a convertible bond similar enough to straight debt, enabling us to use the yield to maturity? Or is it like equity, enabling us to use the CAPM? In actuality, it is neither, so we recommend an alternative method. If the treatment of hybrid securities will make a material difference in valu- ation results,30 we recommend using adjusted present value (APV). In the APV model, enterprise value is determined by discounting free cash flow at the industry-based unlevered cost of equity. The value of incremental cash flows related to financing, such as interest tax shields, is then computed separately. 30 If the hybrid security is out-of-the-money and unlikely to be converted, it can be treated as traditional debt. Conversely, if the hybrid security is well in-the-money, it should be treated as traditional equity. In these situations, errors are likely to be small, and a WACC-based valuation remains appropriate. Closing Thoughts  333 In some situations, you may still desire an accurate representation of the WACC. In these cases, split hybrid securities into their individual components. For instance, you can replicate a convertible bond by combining a traditional bond with a call option on the company’s stock. You can further disaggregate a call option into a portfolio consisting of a risk-free bond and the company’s stock. By converting a complex security into a portfolio of debt and equity, you once again have the components required for the traditional cost of capi- tal. The process of using replicating portfolios to value options is discussed in Chapter 39. Closing Thoughts The cost of capital is one of the most hotly debated topics in the field of finance. While robust statistical techniques have improved our understanding of the issues, a practical measurement of the cost of capital remains elusive. None- theless, we believe the steps outlined in this chapter, combined with a healthy perspective of long-term trends, will lead to a cost of capital that is reliable and reasonable. Even so, do not let a lack of precision overwhelm you. A company creates value when ROIC exceeds the cost of capital, and for many of our cli- ents, the variation in ROIC across projects greatly exceeds any variation in the cost of capital. Smart selection of strategies and their corresponding invest- ments based on forward-looking ROIC, not a precise measurement of the cost of capital, often generates most of the impact in day-to-day decision making.