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*all supplemental material is attached. ASSIGNMENT The assignment is broken down into three parts: 1) Estimating the cost of equity (re) across different mixes of debt and equity 2) Estimating the cost of debt (rd) across different mixes of debt and equity 3) Estimating the weighted average cost of capital (WACC) across different mixes of debt and equity After completing the steps in each section, you are required to summarize your findings and discuss the assumptions that you made during your calculations. An explanation of what should be handed in is provided under the deliverable heading at the end of the document. ESTIMATING THE COST OF EQUITY (re) The cost of equity represents the required return of the shareholders based upon their perception of the riskiness of the firm’s projects. In Module 3 you estimated the current cost of equity for the firm based upon an estimate of the levered beta for the firm. Since the beta changes as the amount of debt changes, you now need to re-estimate the beta for different levels of debt. This is completed through the following steps and the excel template provided on Blackboard. Go the cost of equity tab Refer to your module 3 assignment and the beta you chose as your best representation of the firm The spreadsheet will calculate the unlevered beta based upon your choices in step 2 and update the appropriate cell on the template. Also enter the market capitalization, book level of debt, market risk premium, risk free rate and tax rate in the appropriate cells on the template. Use the same assumptions that you did in Module 3 – Market capitalization and debt are from the Bloomberg screenshot on the WACC (“firm_WACC”), the risk free rate should be changed to be the same used in Module 3 unless you feel a change is necessary. The spreadsheet will calculate a levered beta from the unlevered beta for debt levels of 5%, 10%, 15%… increasing by 5% each time until you reach 100% debt after you enter the correct formula. You can enter the formula for the levered beta and link it to the unlevered beta, the D/E and the tax rate. Once you have the formula entered for 5% debt, just copy the formula for each of the other debt levels. Make sure to lock the cells for the unlevered beta and tax rate (using the $ in front of the number in the formula). Excel will use your estimates of beta and the other assumptions from the CAPM to calculate new estimates of the cost of equity at each level of debt. From the module 3 assignment, the cost of equity is calculated from the Capital Asset Pricing Model (CAPM). The CAPM states: re = rRF + (Beta)(rM-rRF) where: re = the cost of equity or required return of the shareholders rM = the market risk premium rRF = the risk free rate (rM – rRF) = the market risk premium = the extra return for investing in the market portfolio vs. a risk free asset ESTIMATING THE COST OF DEBT (rd) On Blackboard is a list of the outstanding bonds for the firm and their YTM that you used in Module 3. The YTM represents the yield you will earn if you buy the bond today and hold it until maturity. It also represents the coupon rate the firm would have to pay on new debt if it was issued today. Notice there is a wide range of maturity dates for the debt. Bonds with similar maturity dates have similar YTMs, based upon the credit risk of the firm and the market. The bond rating provides a measure of credit risk. Bonds with similar ratings (and similar maturities) should have similar YTM. The spreadsheet already has yield spreads entered corresponding to different debt ratings. The debt rating will be estimated based upon the interest coverage ratio. Bonds with the same debt rating should pay a similar return. Calculating the cost of debt at various debt levels is a multi-step process. At each level of debt, you need to calculate an interest coverage ratio based upon on assumed interest rate. Check to see if the interest coverage ratio implied by your assumed rate is consistent with the assumed rate. If it is you can go to the next level of debt, if it isn’t you need to adjust your assumed interest rate. The template will help you walk through these steps. Go to the cost of debt tab. In the blue column labeled Assumed Rate start with an assumed rate of .01 for the 5% debt row. The cost of debt based upon your assumed rate (linked to the corresponding interest coverage ratio) is shown in the Cost of Debt column. If the Cost of debt matches your assumed rate, you can proceed to the next debt level. If it does not match, type in the cost of debt into your assumed rate. Check again to see if the cost of debt and assumed rate match and continue to change the assumed rate until the two columns match. Once they match, move to the next level of debt. Start the next level with the assumption that it is equal to the final amount in the level prior. Work your way down the column to find a cost of debt at each level of debt. (the example in the notes does this for reference) ESTIMATING THE WEIGHTED AVERAGE COST OF CAPITAL The WACC combines the cost of debt and cost of equity to determine the cost of raising funds to finance its operations. (think about the right hand side of the balance sheet). The capital structure is the mix of debt and equity. We are going to assume that there is no preferred stock and just look at the combination of debt and equity. On Blackboard is a screen shot from Bloomberg with an estimate of the WACC. It provides you with the market capitalization, level of long-term debt, and tax rate. Use those values to estimate the WACC using your estimates for re and rd in the following formula: WACC=(W_d )(r_d )(1-tax rate)+(W_e )(r_e ) or substituting in for Wd and We WACC=(Debt/(Debt+Market Capitalization))(r_d)(1-tax rate)+((Market Capitalization)/(Debt+Market Capitalization))(r_e) The spreadsheet captures the cost of debt and cost of equity at each level of debt and calculates the WACC at each level of debt. It also produces a graph of the WACCs across the range of debt levels. DELIVERABLE In a word document make sure to provide a header / sentence / title stating which firm you are analyzing then cut and paste the following results from your excel spreadsheet into your document. Your assumptions entered into the cost of equity tab (the box at the top of the spreadsheet) The table showing the cost of equity at different debt levels The table showing the cost of debt at different debt levels The table showing the WACC at varies level of debt The graph of the WACC across the levels of debt Following your results provide an analysis of the use of debt by the firm compared to your estimate of the optimal capital structure. Make sure to address the following points Calculations (18 points): What is your estimate of the optimal debt ratio (capital structure) for your firm and how does your estimate compare to the current level of debt? Assumptions (18 points) An analysis of how the assumptions you made when in your calculations impacted your results. Some possible things to consider that may or may not have had an impact on your results (identify which ones you think are more and less important and explain your reasoning) The process for the cost of debt assumes the times interest earned is a good proxy for measuring credit risk, what other financial variables, if any should be considered (is interest coverage the only variable that provides information about ability to pay? Are there other ratios that might help? Can interest coverage be misleading? given it uses EBIT not cash flow?) We adjust the interest coverage ratio assuming the total amount of debt is financed at the cost of debt in the chart (essentially refinancing all of the firm’s debt) is this realistic? – does this assumption limit the applicability of your results (if so, how)? The base level of interest rates, the risk free rate, and yield spreads all change over time. How important are the changes in calculating the optimal level? Since the estimate is based on the current environment does it matter if these inputs change based on the economic environment? Do changes in these inputs increase or decrease the accuracy of estimate of the optimal capital structure – why and/or how? The firm will likely not make drastic changes in its capital structure frequently – do you think your estimate would remain relatively stable as these variables change or would it change frequently and how would that impact the firm’s decisions? The starting value for beta (the original number you entered in the spreadsheet from module 3) may change over time, does this limit your results or is using the current beta an appropriate assumption (explain – how consistent do you think Beta is over time, how do changes in the market environment impact beta – or do they?)? The credit spreads can change as the broad economy changes. The spread used represent estimates of the current yield spreads based on a ten year maturity for different bond ratings, is this the best approach or would an average spread for each credit risk level be more appropriate. Position/Conclusions (18 points): Bringing in reasonable constraints into the decision process and any limitations identified in the assumptions, what would your recommended level of debt be for this firm? (Should the firm move toward the optimal level or stay at its current level?) Make sure to consider if any of the following points influence your recommendation: (the importance of any of these depend upon your firm, its goals, its current level of debt, and your results)) A discussion of how changes in the capital structure would impact the credit rating for the firm and how the financial markets and debt holders would react to a change in the rating. Is the current debt rating consistent with the ratings estimated by what they would be in the model used in this assignment? If there are other considerations (such as a desire for flexibility, attempts to signal information to the market, management’s view of debt, industry standards, etc) that could impact your recommendation How does your firm compare to other firms in the industry in its use of debt (values for comparison will be provided from Bloomberg)? If you recommend changing the level of debt explain if the firm should attempt to change it quickly or gradually. Presentation (6 points): Please submit your final document via Blackboard prior to the due date. Your document should be a well-organized final product that has been proofread. Make sure any data, graphs, or other representation of quantitative data is labeled and readable. In short, it should be a professional document suitable for the workplace. Points can and will be deducted for unorganized documents, poorly written documents, grammatical errors (including spelling), and poorly constricted or incomplete representations of data.
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