Question

Please use the most recent data available for Home Depot. Thank you!

*Excel not necessary if you can't attach, a word doc is fine*

Data Case for Chapter 14:

Capital Structure in a Perfect Market 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 isn’t quite sure what that means. You know that capital structure is irrelevant under the conditions of perfect markets 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 Eq. 14.5 and Eq. 14.6, and assuming a cost of unlevered equity (rU) of 12%.

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

a. Go to www.nasdaq.com, and under “Quotes and Research” click “Summary Quotes.” Enter Home Depot’s stock symbol (HD) and click “Go Now.” 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.

b. Click “Income Statement” 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.” (You will not need the income statement until Chapter 15, but collect all of the background data in one step.) On the Web page, 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.

c. To get the cost of debt for Home Depot, go to FINRA’s Bond Center (http://finra- markets.morningstar.com/BondCenter/). Select the “Corporate” option, enter Home Depot’s symbol, and click “Search.” The next page will contain information for all of Home Depot’s outstanding and recently matured bonds. Select the latest yield on an outstanding bond with the shortest remaining maturity (the maturity date is on the line describing each issue; sometimes the list also contains recently retired bonds, so make sure not to use one of those). For simplicity, since you are just trying to illustrate the main concepts for your boss, you may use the existing 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; include both Long-Term Debt and Short-Term Debt/Current Portion of Long-Term Debt from the balance sheet and subtract any 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 Eq. 14.5.

4. Compute the current weighted average cost of capital (WACC) for Home Depot using Eq. 14.6 given their current debt-to-equity ratio.

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 rDmay change with changes in leverage, for these modestly small changes you decide to assume that rDremains constant. We will explore the relation between changing leverage and changing rD more fully in Chapter 24.) What is the market D/E ratio in each of these cases?

6. Prepare a written explanation for your boss explaining the relationship between capital structure and the cost of capital in this exercise.

7. What implicit assumptions in this exercise generate the results found in Question 5? How might your results differ in the “real world”?

Answer 1

Data Case #3

You work in the corporate finance division of 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. You are asked to calculate the firm’s weighted average cost of capital. You will need to use equations 14.5 and 14.6 and assume a cost of unlevered equity (rU) of 12 percent.

1. Obtain the financial information you need for Home Depot.
   1. Go to www.nasdaq.com , enter Home Depot’s stock symbol (HD) and click “Summary Quotes” . Click “Go.” From the Summary Quotes page, get the current stock price and number of shares outstanding.

37.31 x1638821000 = $ 61144411510

1. Click “Company Financials” and the annual income statement should appear. You will not need the income statement. Click on the Balance Sheet tab. Find the latest annual values for Long-term Debt and Short-Term Debt/Current Portion of Long-Term Debt.

8662000000+1020000000 = 9682000000

1. To get the cost of debt for Home Depot, go to NASD Bond Info (http://cxa.marketwatch.com/finra/BondCenter/Default.aspx) . Select the corporate toggle, search by symbol and enter Home Depot’s symbol. The next page will contain information for all of Home Depot’s outstanding and recently matured bonds. Select the latest yield on an outstanding bond with the longest remaining maturity (the maturity date is on the line describing each issue). For simplicity, you may use the existing yield on the outstanding bond as rD.

http://cxa.marketwatch.com/finra/BondCenter/QuickScreener.aspx?ShowResult=true&BondType=Corporate&Symbol=HD&YieldMin=&YieldMax=&CouponMin=&CouponMax=&MaturityMin=&MaturityMax=

1. Compute the market D/E ratio for Home Depot. Approximate the market value of debt by the book value of net debt; using the values for Long-term Debt and Short-Term Debt/Current Portion of Long-Term Debt that you found in 1b.

Use the stock price and number of shares outstanding from 1a. to calculate the market value of equity.Remember that the values on the Balance Sheet are given in 000’s.

9682000000/61144411510 = .1583 or 15.83%

1. Compute the cost of levered equity (rE) for Home Depot using their current market debt-to-equity ratio and Equation 14.5.

Cost of Capital of Levered Equity: rE= rU + D/E (rU - rD)

rE = 10% + .16 x 10%-6% = 10.64 or 11%

The cost of unlevered equity is 10% assumed

1. Compute the current weighted average cost of capital (WACC) for Home Depot using Eq. 14.6 given their current debt-to-equity ratio.

E/E+D rE + D/E+D rD

rU = (Fraction of Firm Value Financed by Equity) (Equity Cost of Capital) + (Fraction of Firm Value Financed by Debt) (Debt Cost of Capital)

.84 x .11 + .16 x .06 = .102 or 10.2%

1. Write a paragraph explaining the importance and uses of a company’s WACC.
2. Capital is the source of fiancé through which resources are provided. It may be debt financing or equity financing. The cost of debt financing is interest which is the before tax cost of capital, while after tax cost of capital is r (1-t). If suppose the interest rate is 10% and the rate of tax is 20%, it means that before tax cost of capital is 10% and after tax cost of capital is 8%.

In equity finance the cost of capital is dividend. If the rate of dividend is 10%. The after tax cost of capital and before tax cost of capital are same, which is 10% as there is no tax shield available, as the dividend is not the expense, rather it is distribution of profit.

If a project is financed only from debt financing the cost of capital will be 8% and if it is only financed from equity the cost will be 10%. But if financing is done 50% from each, then the cost of capital will be 9%.

The increase in debt financing will reduce the overall cost of capital. For example if we raise the portion of debt financing to 60%, now the cost of capital will be 8.8%.

You can see that the percentage of financing provided from a source determines the weightage of financings. Another example can help, suppose a project requires $200 million and $120 from debt and $80 million from equity financing is provided therefore the weightage of debt is 60% and of equity it is 40%. Now to calculate WACC we will take 60% of the cost of debt and the after tax cost of debt is 8%, while the 60% of 8% is 4.8% and we will take 40% of cost of equity and the after tax cost of equity is 10%, we will take 40% of 10% which is 4%. Now add 4.4% and 4%, the WACC is 8.8% of the project financing.