Compute the cost of levered equity (Re) for home depot using their current market debt-to- equity ratio
You work in the corporate finance division of The Home
Depot and your boss has asked you to review the firms capital
structure. Specifically, your boss is considering changing
the firms debt level. Your boss remembers something from his
MBA program about capital structure being irrelevant, but isnt
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
Depots 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
1 Obtain the financial info you need for Home
A. go to www.nasdaq.com click summary quotes on the
left-hand side and enter Home Depots stock symbol (HD). Click
go from the summary quotes page, get the current stock price and
number of shares outstanding
B. click company financials and the annual income state
should appear. Put the cursor in the middle of the statement,
right-click your mouse, and select export to Microsoft excel.
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.
c. to get the cost of debt for the Home Depot, go to NASD
select the corporate toggle, search by symbol and enter Home Depots
symbol. The next page will contain information for all of
Home Depots 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 to the book value of net debt;
include both Long-Term debt and short-term debt/ current portion of
long-term debt form 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
4 compute the current weighted average cost of capital
(WACC) for home depot given their current debt-to-equity
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. 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.