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##### Capital Structure in a Perfect Market

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Question;Data Case;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. 14.7 from this chapter (see equations below), and assuming a cost of;unlevered equity (rU) of 12 percent.;Obtain the;financial information you need for Home Depot.Go;to Nasdaq.com (http://www.nasdaq.com), click on \"Summary;Quotes\" on the left-hand side, and enter Home Depot?s stock symbol;(HD). Click on Go. From the Summary Quotes page, get the current stock;price and number of shares outstanding.Click;on \"Company Financials\" 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.) Go back to the Nasdaq Web page and select;the balance sheet. Export that 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 for Home Depot, go to NASD BondInfo (http://www.nasdbondinfo.com). 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 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).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.Compute the cost;of levered equity (rE) for Home Depot using their;current market debt-to-equity ratio and Eq. 14.5 from the chapter.Compute the;current weighted average cost of capital (WACC) for Home Depot using Eq.;14.7 and the existing yield on the outstanding bonds as rD;given their current debt-to-equity ratio.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. We will;explore the relation between changing leverage and changing rD;more fully in Chapter 16.) What is the market D/E ratio in each of these;cases?Prepare a;written explanation for your boss explaining the relationship between;capital structure and the cost of capital in this exercise.What implicit;assumptions in this exercise generate the results found in question 5? How;might your results differ in the \"real world\"?;Equations;14.5 - According to MM Proposition II, the cost of capital for;levered equity is;14.7;? Debt is less risky than equity, so it has a lower cost;of capital. Leverage increases the risk of equity, however, raising the equity;cost of capital. The benefit of debt?s lower cost of capital is offset by the;higher equity cost of capital, leaving a firm?s weighted average cost of;capital (WACC) unchanged with perfect capital markets

Paper#49739 | Written in 10-Dec-2015

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