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Objective Before you start Inputs Units Income inputs

Balance Sheet

Market Data

Tax Rate Default Spreads

Summary

Details

PRELIMINARY STUFF AND INPUTS This spreadsheet allows you to compute the optimal capital structure for a financial service firm. Open preferences in excel, go into calculation options and put a check in the iteration box. If it is already checked, leave it as is. The inputs are primarily in the input sheet. If your company has operating leases, use the operating lease worksheet to enter your lease or rental commitments. Enter all numbers in the same units (000s, millions or even billions) The key income input is the earnings before long term interest expenses and depreciation. Enter the most updated numbers you have for each (even if they are 12-month trailing numbers). If the most recent period for which you have data has an operating income that is abnormal, either because of extraordinary losses/gains or some other occurrence, use an average operating income over the last few years. Earnings before long term interest exp & depr = Net Income + taxes paid + long term interest expenses If long term interest expenses are not broken out, apportion the total interest expenses based upon how much long term debt the firm has, relative to total interest bearing debt. From the statement of cash flows, also enter the capital spending from the recent period. P.S: For financial service firms, both depreciation and capital spending are likely to be small numbers. Enter the book value of long term debt. If you have a market value enter that number. Alternatively, input the average maturity of the debt and I will estimate the market value of debt. Enter the current stock price, the current long-term government bond rate, the risk premium you would like to use to estimate your cost of equity and the current rating for your firm. If you do not have a rating, there is an option for you at the very bottom of the spreadsheet to compute a synthetic rating. Enter a marginal tax rate, if you can estimate it. Otherwise, use the effective tax rate. This spreadsheet has interest coverage ratios, ratings and default spreads built into it in the worksheet. You can choose between two tables, one for large and stable firms, and the other for small or risky firms. If you want you can change the interest coverage ratios and ratings in these tables. READING THE OUTPUT The summary provides a picture of your firm's current cost of capital and debt ratio, and compares it to your firm's optimal debt ratio and the cost of capital at that level. The firm value is computed at each debt ratio, based upon how the expected operating income and the cost of capital. The optimal debt ratio is that ratio at which firm value is maximized. It might not be the same point at which cost of capital is minimized. The details of the calculation at each debt ratio are below the summary.

References Corporate Finance: Theory and Practice, Chapter 18 Applied Corporate Finance: Chapter 8

l structure for a financial

put a check in the iteration box.

y has operating leases, ntal commitments.

rest expenses and depreciation. f they are 12-month trailing a has an operating income that r some other occurrence, use

me + taxes paid + long term

n the total interest expenses to total interest bearing debt. ending from the recent period. tal spending are likely to be

et value enter that bt and I will estimate the

ment bond rate, the risk uity and the current rating for r you at the very bottom of

use the effective tax rate. efault spreads built into it in r large and stable ou can change the interest

of capital and debt ratio, and f capital at that level. The the expected operating income at which firm value is capital is minimized.

Question Q1: What do I do excel says there are circular references? Q2: My spreadsheet has gone crazy. I get errors all over. What did I do wrong? Q3: I am entering the inputs for my company but the optimal numbers do not seem to change from the originals Q4: I am getting an optimal debt ratio of 0%. This can't be right. Can it?

Q5: My cost of capital at my optimal debt ratio is higher than the current cost of capital. I thought it was supposed to be lower.

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 interest coverage 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.

Inputs
Please enter the name of the company you are analyzing: Financial Information Earnings before long term interest expenses, depreciation & amortization Depreciation and Amortization: Capital Spending: Interest expense on long term debt: Tax rate on ordinary income: Current Rating on long term debt (if available): Interest rate based upon rating: Market Information Number of shares outstanding: Market price per share: Beta of the stock: Book value of long term debt: Can you estimate the market value of the long term debt? If so, enter the market value of debt: Do you want me to try and estimate market value of debt? If yes, enter the average maturity of outstanding debt? Do you have any operating leases? General Market Data Current long-term (LT) government bond rate: Risk premium (for use in the CAPM) General Data Which spread/ratio table would you like to use for your anlaysis? Do you want to assume that existing debt is refinanced at the 'new' rate? Do you want the firm's current rating to be adjusted to the synthetic rating? 1 Yes Yes (Yes or No) (Yes or No) 6.00% 6.31% (in percent) (in percent) Yes 3.00 No 173.768 $26.43 1.10 $3,573.00 No $1,203.84 $0.00 $0.00 $528.84 35.00% A+ 6.80% Summit

Inputs for synthetic rating estimation

Enter the type of firm = 1 (Enter 1 if large financial service firm, 2 if smaller financial service firm) Earnings before interest and taxes (EBIT) = $1,203.84 (Add back only long term interest expense fo Current interest expenses = $528.84 (Use only long term interest expense for fina Current long term government bond rate = 6.00% Output Interest coverage ratio = 2.28 Estimated Bond Rating = A+ Estimated Default Spread = 0.85% Estimated Cost of Debt = 6.85% For large financial service firms If interest coverage ratio is > to Rating is -100000 0.049999 D 0.05 0.099999 C 0.1 0.199999 CC 0.2 0.299999 CCC 0.3 0.399999 B0.4 0.499999 B 0.5 0.599999 B+ 0.6 0.749999 BB 0.75 0.899999 BB+ 0.9 1.199999 BBB 1.2 1.49999 A1.5 1.99999 A 2 2.49999 A+ 2.5 2.99999 AA 3 100000 AAA For smaller and riskier financial service firms If interest coverage ratio is greater than to Rating is -100000 0.049999 D 0.05 0.099999 C 0.1 0.199999 CC 0.2 0.299999 CCC 0.3 0.399999 B0.4 0.549999 B 0.55 0.699999 B+ 0.7 0.999999 BB 1 1.199999 BB+ 1 1.499999 BBB 1.5 1.999999 A2 2.499999 A 2.5 2.999999 A+ 3 3.499999 AA 3.5 100000 AAA

Spread is 15.00% 12.00% 10.00% 8.00% 5.25% 5.00% 3.75% 3.35% 3.00% 1.60% 1.10% 1.00% 0.85% 0.65% 0.50%

Drop in EBITDA -50.00% -40.00% -40.00% -40.00% -25.00% -20.00% -20.00% -20.00% -20.00% -20.00% -17.50% -15.00% -10.00% -5.00% 0.00%

Spread is 15.00% 12.00% 10.00% 8.00% 5.25% 5.00% 3.75% 3.35% 3.00% 1.60% 1.10% 1.00% 0.85% 0.65% 0.50%

Drop in EBITDA -50.00% -40.00% -40.00% -40.00% -25.00% -20.00% -20.00% -20.00% -20.00% -20.00% -17.50% -15.00% -10.00% -5.00% 0.00%

er financial service firm) Add back only long term interest expense for financial firms) Use only long term interest expense for financial firms)

CAPITAL STRUCTURE

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Summit
Capital Structure Current MV of Equity = $4,593 Market Value of interest-bearing$4,326 debt = # of Shares Outstanding = 173.768 Debt Value of Operating leases (if any) $0 Risk Premium = 6.31% Financial Market Current Beta for Stock = 1.10 Current Bond Rating = A+ Summary of Inputs Long Term Government Bond6.00%= Rate Pre-tax cost of debt = 6.80% Income Statement Current EBITDA = $1,204 Current Depreciation = $0 Current Tax Rate = 35.00% Current Capital Spending= $0 Current Interest Expense = $529

RESULTS FROM ANALYSIS Current Optimal D/(D+E) Ratio = 48.50% 70.00% Beta for the Stock = Cost of Equity = AT Interest Rate on Debt = 1.1 12.94% 4.45% 1.72 16.84% 4.23% 8.01% $10,926 $37.98

Change 21.50% 0.62 3.89% -0.23% -0.82% $2,007 $11.55 Implied Growth Rate Calculation Value of Firm = $8,919 Current WACC = 8.82% Current FCFF = $782.50 ! I am ignoring working capital Implied Growth Rate = 0.05% If this number is >your riskfree rate, I use the riskfree rate as a perpetual growth rate.

Assumes perpeutal growth

WACC 8.82% Implied Growth Rate = 0.05% Firm Value (Perpetual Growth) = $8,919 Value/share (Perpetual Growth) = $26.43

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 Drop in EBITDA Current Interest coverage ratio = 2.28 AAA 3 100000 0.50% 0.00% Rating based upon coverage = A+ AA 2.5 2.99999 0.65% -5.00% Interest rate based upon coverage = 6.85% A+ 2 2.49999 0.85% -10.00% Current rating for company = A+ A 1.5 1.99999 1.00% -15.00% Current interest rate on debt = 6.80% A1.2 1.49999 1.10% -17.50% Drop in operating income based on current rating -10.00% BBB 0.9 1.199999 1.60% -20.00% BB 0.6 0.749999 3.35% -20.00% B+ 0.5 0.599999 3.75% -20.00% B 0.4 0.499999 5.00% -20.00% B0.3 0.399999 5.25% -25.00% CCC 0.2 0.299999 8.00% -40.00% CC 0.1 0.199999 10.00% -40.00% C 0.05 0.099999 12.00% -40.00% D -100000 0.049999 15.00% -50.00%

CAPITAL STRUCTURE
Current beta= Current Debt= Tax rate= 1.10 $4,326 35.00% Current Equity= $4,593 Current Depreciation= Current EBITDA= $1,204 Current Interest rate (Company)= Current Rating= A+ Current T.Bond rate= Adjusted EBITDA = $1,338 WORKSHEET FOR ESTIMATING RATINGS/INTEREST RATES 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 25.00% 42.86% 66.67% 100.00% 150.00% 233.33% $1,784 $2,676 $3,568 $4,460 $5,351 $6,243 0.79 0.87 0.98 1.13 1.35 1.72 11.00% 11.50% 12.17% 13.10% 14.50% 16.84% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% $1,338 $1,338 $1,338 $1,338 $1,338 $1,338 $0 $0 $0 $0 $0 $0 $1,338 $1,338 $1,338 $1,338 $1,338 $1,338 $116 $174 $232 $290 $348 $406 $1,222 $1,164 $1,106 $1,048 $990 $932 $428 $407 $387 $367 $346 $326 $794 $756 $719 $681 $643 $606 $0 $0 $0 $0 $0 $0 $794 $756 $719 $681 $643 $606 11.54 0.45 AAA 6.50% 35.00% 7.69 5.77 4.61 0.28 0.20 0.15 AAA AAA AAA 6.50% 6.50% 6.50% 35.00% 35.00% 35.00% COST OF CAPITAL CALCULATIONS 20.00% 30.00% 40.00% 50.00% 25.00% 42.86% 66.67% 100.00% $1,784 $2,676 $3,568 $4,460 11.00% 11.50% 12.17% 13.10% 4.23% 4.23% 4.23% 4.23% 9.65% 9.32% 8.99% 8.66% 0 0 0 0 $9,059 $9,379 $9,723 $10,094 3.85 0.12 AAA 6.50% 35.00% 60.00% 150.00% $5,351 14.50% 4.23% 8.34% 0 $10,493 3.30 0.10 AAA 6.50% 35.00% 70.00% 233.33% $6,243 16.84% 4.23% 8.01% 1 $10,926 $0 6.80% 6.00%

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D/(D+E) 0.00% D/E 0.00% $ Debt $0 Beta 0.68 Cost of Equity 10.31% % Drop in EBITDA0.00% EBITDA $1,338 Depreciation $0 EBIT $1,338 Interest $0 Taxable Income $1,338 Tax $468 Net Income $869 (+)Deprec'n $0 Funds from Op. $869 Pre-tax Int. cov Funds/Debt Likely Rating AAA Pre-tax cost of debt 6.50% Eff. Tax Rate 35.00% D/(D+E) 0.00% D/E 0.00% $ Debt $0 Cost of equity 10.31% Cost of debt 4.23% Cost of Capital 10.31% 0 Value (perpetual growth) $8,479

10.00% 11.11% $892 0.73 10.62% 0.00% $1,338 $0 $1,338 $58 $1,280 $448 $832 $0 $832 23.07 0.93 AAA 6.50% 35.00% 10.00% 11.11% $892 10.62% 4.23% 9.98% 0 $8,759

80.00% 400.00% $7,135 2.46 21.50% -10.00% $1,204 $0 $1,204 $489 $715 $250 $465 $0 $465 2.46 0.07 A+ 6.85% 35.00% 80.00% 400.00% $7,135 21.50% 4.45% 7.86% 0 $10,017

90.00% 900.00% $8,027 4.67 35.49% -10.00% $1,204 $0 $1,204 $550 $654 $229 $425 $0 $425 2.19 0.05 A+ 6.85% 35.00% 90.00% 900.00% $8,027 35.49% 4.45% 7.56% 0 $10,424

Interest cov Interest cov Low High

RATING

Interest rate

Drop in EBITDA

CAPITAL STRUCTURE
-100000 0.05 0.1 0.2 0.3 0.4 0.5 0.6 0.75 0.9 1.2 1.5 2 2.5 3 0.049999 0.099999 0.199999 0.299999 0.399999 0.499999 0.599999 0.749999 0.899999 1.199999 1.49999 1.99999 2.49999 2.99999 100000 D C CC CCC BB B+ BB BB+ BBB AA A+ AA AAA 21.00% 18.00% 16.00% 14.00% 11.25% 11.00% 9.75% 9.35% 9.00% 7.60% 7.10% 7.00% 6.85% 6.65% 6.50% -50.00% -40.00% -40.00% -40.00% -25.00% -20.00% -20.00% -20.00% -20.00% -20.00% -17.50% -15.00% -10.00% -5.00% 0.00%

19

CAPITAL STRUCTURE

20

te as a perpetual growth rate.

Chart - Cost of Equity

Cost of Equity and Beta: Debt Ratios


5.00 40.00%

4.50

35.00%

4.00
30.00% 3.50 25.00%

3.00

2.50

20.00%
Beta Cost of Equity

2.00

15.00%

1.50 10.00% 1.00 5.00%

0.50

0.00 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

0.00%

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

Beta 0.68 0.73 0.79 0.87 0.98 1.13 1.35 1.72 2.46 4.67

Cost of Equity Bond Rating Interest rate on debt 10.31% AAA 6.50% 10.62% AAA 6.50% 11.00% AAA 6.50% 11.50% AAA 6.50% 12.17% AAA 6.50% 13.10% AAA 6.50% 14.50% AAA 6.50% 16.84% AAA 6.50% 21.50% A+ 6.85% 35.49% A+ 6.85%

Tax Rate Cost of Debt (after-tax) 35.00% 4.23% 35.00% 4.23% 35.00% 4.23% 35.00% 4.23% 35.00% 4.23% 35.00% 4.23% 35.00% 4.23% 35.00% 4.23% 35.00% 4.45% 35.00% 4.45%

WACC 10.31% 9.98% 9.65% 9.32% 8.99% 8.66% 8.34% 8.01% 7.86% 7.56%

Firm Value (G) $8,479 $8,759 $9,059 $9,379 $9,723 $10,094 $10,493 $10,926 $10,017 $10,424