capstru

8/8/2019 capstru

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Objective

Before you start

Inputs

Units

Income inputs

Balance Sheet

Market Data

Tax Rate

Default Spreads

Summary

Details

References

Corporate Finance

Applied Corporate

8/8/2019 capstru


8/8/2019 capstru


Question

Q1: What do I do excel says there are circular referen

Q2: My spreadsheet has gone crazy. I get errors all ov

What did I do wrong?

Q3: I am entering the inputs for my company but the

optimal numbers do not seem to change from theoriginals

Q4: I am getting an optimal debt ratio of 0%. This ca

be right. Can it?

Q5: My cost of capital at my optimal debt ratio is hig

than the current cost of capital. I thought it was suppo

to be lower.

8/8/2019 capstru


Answer

Go into preferences, choose calculation options and make sure the iteration box has a check in it.

I am sorry to say this, but you probably just made an input error. While you might have

fixed it, the iterations in the spreadsheet make it very sensitive and the errors will not

go away. The only fix (Sorry, sorry…) is to copy the inputs into a fresh version of the spreadsheet.

You probably forgot to check the iteration box (see Q1)

Sure. If your operating income is either negative or very low, relative to your firm value,

you can end up at an optimal debt ratio of 0%. For instance, if you have EBIT of 100 on a

firm value of 10000, a 10% debt ratio would probably push you into a C rating and give

you a very high cost of capital.

Generally, you are right. However, I would suggest that you look at three factors:

- If your optimal is just slightly higher or lower than your current debt ratio, it is possible that you

are closer to the optimal than the stated optimal. Let me explain. Assume that you are at a 24% debt ratio

and the optimal comes out to 30%. The true optimal is really somewhere around 30% since

I am constrained to work in 10% increments of the debt ratio. If the true optimal were

26%, your current debt ratio of 24% is closer to the optimal.

- Rating Differences: One of the costs of rating a company based only on the interestcoverage ratio is that the rating might be very different from the actual rating. Thus, your

current cost of capital is based upon your current rating, and the optimal is based upon

the synthetic ratings, and the two don't match, the current and the optimal cost of capital

can be mismatched. You can get around this by switching to a synthetic rating for computing

the current cost of capital (in the input sheet).

- Existing debt at low rates: I assume in the spreadsheet that existing debt gets refinanced at

the new pre-tax cost of debt at each debt ratio. Consequently, if you have a lot of old debt on

your books at much lower rates, the interest expense that I report will be much higher than

your actual interest expense. This, in turn, can affect your interest coverage ratio and rating.

This, too, you can fix by locking in debt at current rates in the input sheet.

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Inputs

Please enter the name of the company you are analyzing: Walt Disney

Financial Information

Earnings before interest, taxes and depreciation (EBITDA) $3,790.00

Depreciation and Amortization: $1,077.00

Capital Spending: $1,049.00

Interest expense on debt: $666.00

Tax rate on ordinary income: 37.30%

Current Rating on debt (if available): BBB+

Interest rate based upon rating: 5.25%

Market Information

Number of shares outstanding: 2475.09

Market price per share: $22.26

Beta of the stock: 1.25

Book value of debt: $13,100.00

Can you estimate the market value of the outstanding debt? No

If so, enter the market value of debt:

Do you want me to try and estimate market value of debt? Yes

If yes, enter the average maturity of outstanding debt? 11.53

Do you have any operating leases? Yes

General Market Data

Current long-term (LT) government bond rate: 4.00%

Risk premium (for use in the CAPM) 4.82%

General Data

Which spread/ratio table would you like to use for your anlaysis? 1

Do you want to assume that existing debt is refinanced at the 'new' rate? Yes

Do you want the firm's current rating to be adjusted to the synthetic rating? Yes

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(in percent)

(in percent)

(Yes or No)

(Yes or No)

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Operating Lease CoOperating lease expenses are really financial expenses, and should be treated as such. Acc

be treated as operating expenses. This program will convert commitments to make operati

adjust the operating income accordingly, by adding back the imputed interest expense on t

Inputs

Operating lease expense in current year = $556.00

Operating Lease Commitments (From footnote to financials)

Year Commitment ! Year 1 is next year, ….

1 $271.00

2 $242.00

3 $221.00

4 $208.00

5 $275.00

6 and beyond $1,033.00

Pre-tax Cost of Debt = Err:522 ! If you do not have a cost of debt, use the attached rat

From the current financial statements, enter the following

Reported Operating Income (EBIT) = $2,713.00 ! This is the EBIT reported in the cu

Reported Interest Expenses = $666.00

Output

Number of years embedded in yr 6 estimate = 4 ! I use the average lease expense ov

to estimate the number of years of e

Converting Operating Leases into debt

Year Commitment Present Value

1 $271.00 Err:522

2 $242.00 Err:522

3 $221.00 Err:5224 $208.00 Err:522

5 $275.00 Err:522

6 and beyond $258.25 Err:522 ! Commitment beyond year 6 converted into an annuit

Debt Value of leases = Err:522

Restated Financials

Operating Income with Operating leases reclassified as debt = Err:522

Interest expenses with Operating leases classified as debt = Err:522

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nverterunting standards allow them to

g leases into debt and

his debt.

ings estimator

rrent income statement

r the first five years

xpenses in yr 6

y for ten years

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Inputs for synthetic rating estimationEnter the type of firm = 1 (Enter 1 if large manufacturing firm, 2 if smaller or ris

Enter current Earnings before interest and taxes (EBIT) = Err:522

Enter current interest expenses = Err:522

Enter current long term government bond rate = 4.00%

OutputInterest coverage ratio = Err:522

Estimated Bond Rating = Err:522

Estimated Default Spread = Err:522

Estimated Cost of Debt = Err:522

For large or stable firms

If interest coverage ratio is

> to≤ Rating is Spread is

-100000 0.2 D 20.00%

0.2 0.65 C 12.00%

0.65 0.8 CC 10.00%

0.8 1.25 CCC 8.00%1.25 1.5 B- 6.00%

1.5 1.75 B 4.00%

1.75 2 B+ 3.25%

2 2.25 BB 2.50%

2.25 2.5 BB+ 2.00%

2.5 3 BBB 1.50%

3 4.25 A- 1.00%

4.25 5.5 A 0.85%

5.5 6.5 A+ 0.70%

6.5 8.5 AA 0.50%

8.50 100000 AAA 0.35%

For smaller and riskier firms

If interest coverage ratio is

greater than to≤ Rating is Spread is

-100000 0.5 D 20.00%

0.5 0.8 C 12.00%

0.8 1.25 CC 10.00%

1.25 1.5 CCC 8.00%

1.5 2 B- 6.00%

2 2.5 B 4.00%

2.5 3 B+ 3.25%

3 3.5 BB 2.50%3.5 4 BB+ 2.00%

4 4.5 BBB 1.50%

4.5 6 A- 1.00%

6 7.5 A 0.85%

7.5 9.5 A+ 0.70%

9.5 12.5 AA 0.50%

12.5 100000 AAA 0.35%

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kier firm, 3 if financial service firm)

(Add back only long term interest expense for financial firms)

(Use only long term interest expense for financial firms)

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CAPITAL STRUCTURE

Walt DisneyCapital Structure Financial Market Income Statement

Current MV of Equity = $55,101 Current Beta for Stock = 1.25 Current EBITDA = Err:522

Market Value of interest-bearing d $12,915 Current Bond Rating = BBB+ Current Depreciation = $1,077

# of Shares Outstanding = 2475.09 Summary of Inputs Current Tax Rate = 37.30%

Debt Value of Operating leases (if Err:522 Long Term Government Bond 4.00% Current Capital Spending= $1,049

Risk Premium = 4.82% Pre-tax cost of debt = 5.25% Current Interest Expense = Err:522

RESULTS FROM ANALYSIS

Current Optimal Change

D/(D+E) Ratio = Err:522 Err:522 Err:522

Implied Growth Rate Calculation

Beta for the Stock = 1.25 Err:522 Err:522 Value of Firm Err:522

Cost of Equity = 10.00% Err:522 Err:522 Current WACC Err:522

Current FCFF Err:522 ! I a

AT Interest Rate on Debt = Err:522 Err:522 Err:522 Implied Growt Err:522

If this number is >Riskfree rate, I u

WACC Err:522 Err:522 Err:522

Implied Growth Rate = Err:522

Assumes constant saving Firm Value (no growth) = Err:522 Err:522 Err:522

Assumes perpeutal growth Firm Value (Perpetual Growth Err:522 Err:522 Err:522

Value/share (No Growth) = Err:522 Err:522 Err:522

Value/share (Perpetual Growth Err:522 Err:522 Err:522

We use the following default spreads in our analysis. Change them in the input sheet if necessary: Ratings comparison at current debt ratio

Rating Coverage gt and lt Spread Current Interest coverage ratio = E

AAA 8.5 100000 0.35% Rating based upon coverage = E

AA 6.5 8.5 0.50% Interest rate based upon coverage = E

A+ 5.5 6.5 0.70% Current rating for company =

A 4.25 5.5 0.85% Current interest rate on debt =

A- 3 4.25 1.00%

BBB 2.5 3 1.50%

BB 2 2.25 2.50%

B+ 1.75 2 3.25%

B 1.5 1.75 4.00%

B- 1.25 1.5 6.00%

CCC 0.8 1.25 8.00%

CC 0.65 0.8 10.00%

C 0.2 0.65 12.00%

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CAPITAL STRUCTURE

D -100000 0.2 20.00%

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CAPITAL STRUCTURE

Current beta= 1.25 Current Equity= $55,101 Current Depreciation= $1,077

Current Debt= Err:522 Current EBITDA= Err:522 Current Interest rate (Company)= 5.25%

Tax rate= 37.30% Current Rating= BBB+ Current T.Bond rate= 4.00%

WORKSHEET FOR ESTIMATING RATINGS/INTEREST RATES

D/(D+E) 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00%

D/E 0.00% 11.11% 25.00% 42.86% 66.67% 100.00% 150.00% 233.33% 400.00% 9

$ Debt $0 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

Beta Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522Cost of Equity Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

EBITDA Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

Depreciation $1,077 $1,077 $1,077 $1,077 $1,077 $1,077 $1,077 $1,077 $1,077

EBIT Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

Interest $0 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

Taxable Income Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

Tax Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

Net Income Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

(+)Deprec'n $1,077 $1,077 $1,077 $1,077 $1,077 $1,077 $1,077 $1,077 $1,077

Funds from Op. Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

Pre-tax Int. cov ∞ Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

Funds/Debt ∞ Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

Likely Rating AAA Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

Pre-tax cost of debt 4.35% Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

Eff. Tax Rate 37.30% Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

COST OF CAPITAL CALCULATIONS

D/(D+E) 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00%

D/E 0.00% 11.11% 25.00% 42.86% 66.67% 100.00% 150.00% 233.33% 400.00% 9

$ Debt $0 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

Cost of equity Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

Cost of debt 2.73% Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

Cost of Capital Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

Value (no growth) Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

Value (perpetual gr Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522

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CAPITAL STRUCTURE

Interest cov Interest cov RATING Interest rate

Low High

-100000 0.2 D 24.00%

0.2 0.65 C 16.00%

0.65 0.8 CC 14.00%

0.8 1.25 CCC 12.00%

1.25 1.5 B- 10.00%

1.5 1.75 B 8.00%

1.75 2 B+ 7.25%

2 2.25 BB 6.50%

2.25 2.5 BB+ 6.00%

2.5 3 BBB 5.50%

3 4.25 A- 5.00%

4.25 5.5 A 4.85%

5.5 6.5 A+ 4.70%

6.5 8.5 AA 4.50%

8.5 100000 AAA 4.35%

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CAPITAL STRUCTURE

working capital

ree rate as a perpetual growth rate.

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CAPITAL STRUCTURE 22

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Chart - Cost of Equity

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0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

0.00

2.00

4.00

6.00

8.00

10.00

12.00

0

2

4

6

8

10

12

Cost of Equity and Beta: Debt Ratios

Beta

Cost of Equity

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Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate

0% Err:522 Err:522 AAA 4.35% 37.30%

10% Err:522 Err:522 Err:522 Err:522 Err:522




50% Err:522 Err:522 Err:522 Err:522 Err:52260% Err:522 Err:522 Err:522 Err:522 Err:522




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ost of Debt (after-tax) WACC Firm Value (G)

2.73% Err:522 Err:522

Err:522 Err:522 Err:522

Err:522 Err:522 Err:522

Err:522 Err:522 Err:522

Err:522 Err:522 Err:522

Err:522 Err:522 Err:522Err:522 Err:522 Err:522

Err:522 Err:522 Err:522

Err:522 Err:522 Err:522

Err:522 Err:522 Err:522

capstru

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