You work in the corporate finance division of The Home Depot and your boss has a

Question

You work in the corporate finance division of The Home Depot and your boss has asked you to review the firm’s capital structure. Specifically, your boss is considering changing the firm’s debt level. Your boss remembers something from his MBA program about capital structure being irrelevant, but is not quite sure what that means. You know that capital structure is irrelevant under conditions of perfect markets1 and will demonstrate this point for your boss by showing that the weighted average cost of capital remains constant under various levels of debt. So, for now, suppose that capital markets are perfect as you prepare responses for your boss.

You would like to analyze relatively modest changes to Home Depot’s capital structure. You would like to consider two scenarios: the firm issues $1 billion in new debt to repurchase stock, and the firm issues $1 billion in new stock to repurchase debt. Use Excel to answer the following questions using equations 1 and 2, and assuming a cost of unlevered equity is 12%.

rU= D+E×rD + D+E×rE

Cost of Capital of Levered Equity

rE =rU +(rU rD)D

1. Obtain the financial information you need for Home Depot.

Go to www.nasdaq.com, and hover over the dropdown on the “Quotes” tab along the top menu bar. Click “Summary and Quotes.” Enter Home Depot’s stock symbol (HD) and click “Submit.” From the Stock Quote & Summary Data page, get the current stock price. Click “Stock Report” in the left column and find the number of shares outstanding.

Click “Income Statement” along the left column and the annual income statement should appear. Put the cursor in the middle of the statement, right-click your mouse, and select “Export to Microsoft Excel.” On the Web page, above the income statement, click the Balance Sheet tab. Export the balance sheet to Excel as well and then cut and paste the balance sheet to the same worksheet as the income statement.

To get the cost of debt rD for Home Depot, go to finance.yahoo.com.2 (http://finance.yahoo.com) Hover over “Market Data” and select “Bonds.” Then, select “Bond Screener.”3 Select “Bond Type.” Check “corporate.” Choose Maturity Range “0” min and “2yr” max.4 Choose Fitch Rating Range “BBB” min and “AA” max.5 Click “Find Bonds.” Click “Issue” on Bond Screener Results to alphabetize. Then, scroll down the pages to find “Home Depot” and the “current yield(%).” For simplicity, since you are just trying to illustrate the main concepts

for your boss, you may use the current yield on the outstanding bond as rD.

2.Compute the market D/E ratio for Home Depot. Approximate the market value of debt by the book value of net debt. That is, from the balance sheet, add Long-Term Debt and the Current Portion of Long-Term Debt from current liabilities and subtract cash holdings. Use the stock price and number of shares outstanding to calculate the market value of equity.

3.Compute the cost of levered equity (rE) for Home Depot using their current market debt-to- equity ratio and equation

4. Compute the current weighted average cost of capital (WACC) for Home Depot using equation 1 given their current debt-to-equity.

5.Repeat Steps 3 and 4 for the two scenarios you would like to analyze, issuing $1 billion in debt to repurchase stock, and issuing $1 billion in stock to repurchase debt. (Although you realize that the cost of debt capital rD may change with changes in leverage, for these modestly small changes, you decide to assume that rD remains constant.) What is the market D/E ratio in each of these cases?

Explanation / Answer

3.

Current Debt/Equity=D/E=3.37

rU=cost of unlevered equity = 12%=0.12

cost of debt=rD=1.02%=0.0102 (cost of debt of shortest maturity bond)

use the equation 2) rE =rU +(rU rD)*(D/E)

cost of levered equity=rE =0.12+(0.120.0102)*(3.37)

rE =0.12+0.1098*(3.37)

rE =0.12+0.370026

rE=0.490026=49% is the cost of levered equity (rE).

4.

Wacc=rU= (D/(D+E))×rD + (E/(D+E))×rE

rU=Wacc= ((D/E)/(1+D/E))×rD + (1/(1+D/E))×rE

rU= (3.37/(1+3.37))×0.0102 + (1/(1+3.37))×0.490026

rU=12%

5.

Scenario 1) issuing $1 billion in debt to repurchase stock

Market value of equity=E=current stock price*shares o/s

Market value of equity=E=135.2211*1252951007=169425413412.6477=$169.425 billion

Market value of debt=E*(D/E)=3.37*169.425 billion=$ 570.96225 billion

After repurchase the value of equity=$(169.425-1)billion=$168.425 billion

After issue value of debt=$ (1+570.96225) billion=$ 571.96225 billion

Therefore the new D/E=571.96225/168.425 =3.396

cost of levered equity=rE =0.12+(0.120.0102)*(3.396)=.49288=49.29%

rU= (3.396/(1+3.396))×0.0102 + (1/(1+3.396))×0.49288=12%

Scenario 1) issuing $1 billion in debt to repurchase stock

Market value of equity=E=current stock price*shares o/s

Market value of equity=E=135.2211*1252951007=169425413412.6477=$169.425 billion

Market value of debt=E*(D/E)=3.37*169.425 billion=$ 570.96225 billion

After issue the value of equity=$(169.425+1)billion=$170.425 billion

After repurchase value of debt=$ (-1+570.96225) billion=$ 569.96225 billion

Therefore the new D/E=569.96225 /170.425 =3.344

cost of levered equity=rE =0.12+(0.120.0102)*(3.344)=.4871=48.71%

rU= (3.344/(1+3.344))×0.0102 + (1/(1+3.344))×.4871=12%

The cost of capital remains the same whatever be the capital structure ,whatever be the % of debt and %equity in the capital structure the cost of capital remains the same as we have seen above.Onlt the cost of levered equity changes in direct proportion to the debt to equity ratio whereas the cost of capital remain the same assuming the perfect markets.

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