Based on the attached analysis answer the following questions:

• How large, in qualitative or quantitative terms, are the disadvantages to this company from using debt?
• From the qualitative tradeoff, does this ?rm look like it has too much or too little debt?

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 non-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. Enter the book value of total 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 risk free rate, the equity 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 find it. Otherwise, use the marginal tax rate of country 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 structure for a non-financial put a check in the iteration box. y has operating leases, tal commitments. est expenses and depreciation. they are 12-month trailing a has an operating income that some other occurrence, use t and I will estimate the ity and the current rating for you at the very bottom of the marginal tax rate of country efault spreads built into it in large and stable u can change the interest of capital and debt ratio, and capital at that level. The the expected operating income t which firm value is capital is minimized. Question Q1: What do I do excel says there are circular referen Q2: My spreadsheet has gone crazy. I get 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 hig than the current cost of capital. I thought it was sup to be lower. Q6: I am getting an optimal debt ratio at a mix where of capital is not minimized? Is something wrong? 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. Not necessarily. If you chose to build in indirect bankruptcy costs (an option on the input page), your operating income also changes as your debt ratio changes. Since the objective ultimately is to maximize firm value, it is possible that the net effect (lower cost of capital is good but it could be offset by lower operating income) is resulting in an optimal at a higher debt ratio. Inputs Please enter the name of the company you are analyzing: Stryker Please enter the date that you are doing this analysis Jun-16 Financial Information Earnings before interest expenses, depreciation & amortization (EBITDA) $1,735.00 Depreciation and Amortization: $397.00 Capital Spending: $270.00 Interest expense on debt: $108.00 Marginal tax rate to use for pre-tax cost of debt 17.10% Current Bond Rating on debt (if available): Baa1 Enter the current pre-tax cost of debt for your company 4.63% Market Information & information on debt Number of shares outstanding: 373.98 Market price per share: $113.56 Beta of the stock: Book value of debt: Can you estimate the market value of the interest bearing debt? 0.85 $ 3,253.00 No If so, enter the market value of "interest bearing" debt: Do you want me to try and estimate market value of debt? Yes If yes, enter the weighted average maturity of outstanding debt? 4.00 Do you have any operating leases? Yes Indirect bankruptcy costs & ratings constraints (if any) Do you want to incorporate indirect bankruptcy costs into your optimal? If yes, specify the magnitude of your indirect bankruptcy costs No Medium General Market Data Current riskfree rate in the currency of analysis = 1.63% Risk premium (for use in the CAPM) 5.50% Country Default spread (for cost of debt) 0.00% \\ 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 (Yes or No) Do you want the firm's current rating & cost of debt to be adjusted to the sy no (Yes or No) Country Tax Rate 20.00% Afghanistan 10.00% Albania 35.00% Angola 35.00% Argentina 20.00% Armenia 28.00% Aruba 30.00% Australia 25.00% Austria 0.00% Bahamas 0.00% Bahrain 27.50% Bangladesh 25.00% Barbados 18.00% Belarus 33.99% Belgium 0.00% Bermuda 25.00% Bolivia 0.00% Bonaire Bosnia and He 10.00% 22.00% Botswana 34.00% Brazil 10.00% Bulgaria 20.00% Cambodia 26.00% Canada 0.00% Cayman Islan 18.50% Chile 25.00% China 33.00% Colombia 30.00% Costa Rica 20.00% Croatia 27.50% Curacao 10.00% Cyprus Czech Republi 19.00% 25.00% Denmark Dominican Rep 29.00% 23.00% Ecuador 25.00% Egypt 21.00% Estonia 30.00% El Salvador 28.00% Fiji 24.50% Finland 33.33% France 0.00% Georgia 29.48% Germany 10.00% 20.00% Greece 31.00% Guatemala 0.00% Guernsey 35.00% Honduras 16.50% Hong Kong 19.00% Hungary 20.00% Iceland 32.45% India 25.00% Indonesia 12.50% Ireland 0.00% Isle of Man 25.00% Israel 31.40% Italy 33.33% Jamaica 38.01% Japan 0.00% Jersey 14.00% Jordan 20.00% Kazakhstan 30.00% Kenya Korea, Republi 24.20% 15.00% Kuwait 15.00% Latvia 20.00% Libya 12.50% Liechtenstein 15.00% Lithuania 28.80% Luxembourg 12.00% Macau 10.00% Macedonia 30.00% Malawi 25.00% Malaysia 35.00% Malta 15.00% Mauritius 30.00% Mexico 9.00% Montenegro 32.00% Mozambique 34.00% Namibia 25.00% Netherlands 28.00% New Zealand 30.00% Nigeria 28.00% Norway 12.00% Oman 35.00% Pakistan 25.00% Panama Gibraltar 30.00% 10.00% Paraguay 30.00% Peru 30.00% Philippines 19.00% Poland 25.00% Portugal 10.00% Qatar 16.00% Romania 20.00% Russia 0.00% Saba 27.00% Samoa 20.00% Saudi Arabia 10.00% Serbia 17.00% Singapore Slovak Republ 19.00% 18.00% Slovenia 34.55% South Africa 30.00% Spain 28.00% Sri Lanka 0.00% St Eustatius 34.50% St Maarten 35.00% Sudan 26.30% Sweden 21.17% Switzerland 28.00% Syria 17.00% Taiwan 30.00% Tanzania 23.00% Thailand 25.00% Trinidad and 30.00% Tunisia 20.00% Turkey 30.00% Uganda 21.00% Ukraine United Arab E 55.00% United Kingdo 24.00% 40.00% United States 25.00% Uruguay 0.00% Vanuatu 34.00% Venezuela 25.00% Vietnam 20.00% Yemen 35.00% Zambia 25.75% Zimbabwe Africa average 29.02% Papua New Gu 33.00% 22.89% Asia average Europe averag 20.50% 28.30% Latin America Oceania avera 28.60% 22.60% EU average OECD averag 25.25% Global averag 24.43% North America Operating Lease Converter Operating lease expenses are really financial expenses, and should be treated as such. Accounting standards allow be treated as operating expenses. This program will convert commitments to make operating leases into debt and adjust the operating income accordingly, by adding back the imputed interest expense on this debt. Inputs Operating lease expense in current year = Operating Lease Commitments (From footnote to financials) Year Commitment ! Year 1 is next year, .... $ 69.00 1 $ 51.00 2 $ 39.00 3 $ 28.00 4 $ 20.00 5 56.00 6 and beyond $ Pre-tax Cost of Debt = 4.63% $44.30 ! If you do not have a cost of debt, use the attached ratings estimator From the current financial statements, enter the following Reported Operating Income (EBIT) = $1,338.00 Reported Interest Expenses = $108.00 Output Number of years embedded in yr 6 estimate = 1 ! This is the EBIT reported in the current income statement ! I use the average lease expense over the first five years to estimate the number of years of expenses in yr 6 Converting Operating Leases into debt Year Commitment Present Value 1 $ 69.00 $65.95 2 $ 51.00 $46.59 3 $ 39.00 $34.05 4 $ 28.00 $23.36 5 $ 20.00 $15.95 6 and beyond $ 56.00 $42.68 ! Commitment beyond year 6 converted into an annuity for ten years Debt Value of leases = $ 228.58 Restated Financials Operating Income with Operating leases reclassified as debt = Interest expenses with Operating leases classified as debt = $ 1,348.58 $ 118.58 nverter uch. Accounting standards allow them to e operating leases into debt and ense on this debt. d ratings estimator current income statement over the first five years f expenses in yr 6 nnuity for ten years Inputs for synthetic rating estimation Enter the type of firm = 1 Earnings before interest and taxes (EBIT) = Current interest expenses = Current long term government bond rate = Output Interest coverage ratio = Estimated Bond Rating = Estimated Default Spread = Estimated Cost of Debt = (Enter 1 if large financial service firm, 2 if smaller financial service firm) $1,348.58 (Add back only long term interest expen $118.58 (Use only long term interest expense for 1.63% 11.37 Aaa/AAA 0.40% 2.03% For large manufacturing firms If interest coverage ratio is > to -100000 0.199999 0.2 0.649999 0.65 0.799999 0.8 1.249999 1.25 1.499999 1.5 1.749999 1.75 1.999999 2 2.2499999 2.25 2.49999 2.5 2.999999 3 4.249999 4.25 5.499999 5.5 6.499999 6.5 8.499999 8.50 100000 Rating is D2/D Caa/CCC Ca2/CC C2/C B3/BB2/B B1/B+ Ba2/BB Ba1/BB+ Baa2/BBB A3/AA2/A A1/A+ Aa2/AA Aaa/AAA Spread is 12.00% 10.50% 9.50% 8.75% 7.25% 6.50% 5.50% 4.00% 3.00% 2.00% 1.30% 1.00% 0.85% 0.70% 0.40% Drop in EBITDA 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% For smaller and riskier firms If interest coverage ratio is greater than to -100000 0.499999 0.5 0.799999 0.8 1.249999 1.25 1.499999 1.5 1.999999 2 2.499999 2.5 2.999999 3 3.499999 3.5 3.9999999 4 4.499999 4.5 5.999999 6 7.499999 7.5 9.499999 9.5 12.499999 12.5 100000 Rating is D2/D Caa/CCC Ca2/CC C2/C B3/BB2/B B1/B+ Ba2/BB Ba1/BB+ Baa2/BBB A3/AA2/A A1/A+ Aa2/AA Aaa/AAA Spread is 12.00% 10.50% 9.50% 8.75% 7.25% 6.50% 5.50% 4.00% 3.00% 2.00% 1.30% 1.00% 0.85% 0.70% 0.40% Drop in EBITDA 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% r financial service firm) Add back only long term interest expense for financial firms) Use only long term interest expense for financial firms) Stryker June 4, 2016 Capital Structure Current MV of Equity = $42,469 Market Value of interest-beari $3,101 # of Shares Outstanding = 373.98 Debt Value of Operating leases $229 Equity Risk Premium = 5.50% Financial Market Current Beta for Stock = 0.85 Current Bond Rating = Baa1 Summary of Inputs Long Term Government Bo 1.63% Pre-tax cost of debt = 4.63% RESULTS FROM ANALYSIS Current Optimal D/(D+E) Ratio = 7.27% #REF! Beta for the Stock = Cost of Equity = Rating on Debt After-tax cost of Debt = Assumes perpeutal growth 0.85 6.31% Baa1 3.84% WACC 6.13% Implied Growth Rate = 1.63% Firm Value (Perpetual Gro $45,798 Value/share (Perpetual Gro $113.56 Income Statement Current EBITDA = Current Depreciation = Current Tax Rate = Current Capital Spending= Current Interest Expense = Change #REF! #REF! #REF! #VALUE! #VALUE! #REF! #REF! #REF! #REF! #REF! #REF! #VALUE! #VALUE! We use the following default spreads in our analysis. Change them in the input sheet if necessary: Ratings comparison at current Rating Coverage gt and lt Spread Drop in EBI Current Interest coverage ratio = AAA 8.50 100000 0.40% 0.00% Rating based upon coverage = AA 6.5 8.499999 0.70% 0.00% Interest rate based upon coverage = A+ 5.5 6.499999 0.85% 0.00% Current rating for company = A 4.25 5.499999 1.00% 0.00% Current interest rate on debt = A3 4.249999 1.30% 0.00% Drop in operating income based on cu BBB 2.5 2.999999 2.00% 0.00% BB 2 2.2499999 4.00% 0.00% B+ 1.75 1.999999 5.50% 0.00% B 1.5 1.749999 6.50% 0.00% B1.25 1.499999 7.25% 0.00% CCC 0.8 1.249999 8.75% 0.00% CC 0.65 0.799999 9.50% 0.00% C 0.2 0.649999 10.50% 0.00% D -100000 0.199999 12.00% 0.00% Current beta= 0.85 Current Equity= $42,469 Current Depreciation= Current Debt= $3,329 Current EBITDA= $1,746 Current Interest rate (Com Tax rate= 17.10% Current Rating= Baa1 Current T.Bond rate= Adjusted EBITDA = $1,746 WORKSHEET FOR ESTIMATING RATINGS/INTEREST RATES D/(D+E) 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% D/E 0.00% 11.11% 25.00% 42.86% 66.67% 100.00% 150.00% $ Debt $0 $4,580 $9,160 $13,739 $18,319 $22,899 $27,479 Beta 0.80 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Cost of Equity 6.03% Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 % Drop in EBIT 0.00% Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 EBITDA $1,746 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Depreciation $397 $397 $397 $397 $397 $397 $397 EBIT Interest Taxable Income Tax Net Income (+)Deprec'n Funds from Op. Err:522 #REF! Err:522 #REF! Err:522 $397 Err:522 Err:522 #REF! Err:522 #REF! Err:522 $397 Err:522 Pre-tax Int. cov Funds/Debt Likely Rating Aaa/AAA Pre-tax cost of d 2.03% Eff. Tax Rate 17.10% Err:522 Err:522 #REF! #REF! Err:522 Err:522 Err:522 #REF! #REF! Err:522 D/(D+E) D/E $ Debt Cost of equity Cost of debt Cost of Capital 10.00% 11.11% $4,580 Err:522 Err:522 Err:522 0 #REF! 20.00% 25.00% $9,160 Err:522 Err:522 Err:522 0 #REF! Value (perpetual $1,349 $0 $1,349 $231 $1,118 $397 $1,515 0.00% 0.00% $0 6.03% 1.68% 6.03% 0 $46,904 Err:522 #REF! Err:522 #REF! Err:522 $397 Err:522 Err:522 #REF! Err:522 #REF! Err:522 $397 Err:522 Err:522 #REF! Err:522 #REF! Err:522 $397 Err:522 Err:522 #REF! Err:522 #REF! Err:522 $397 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 #REF! #REF! #REF! #REF! #REF! #REF! #REF! #REF! Err:522 Err:522 Err:522 Err:522 COST OF CAPITAL CALCULATIONS 30.00% 40.00% 50.00% 60.00% 42.86% 66.67% 100.00% 150.00% $13,739 $18,319 $22,899 $27,479 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 Err:522 0 0 0 0 #REF! #REF! #REF! #REF! Interest cov Interest cov RATING Interest rate Low High -100000 0.199999 D2/D 13.63% 0.2 0.649999 Caa/CCC 12.13% 0.65 0.799999 Ca2/CC 11.13% 0.8 1.249999 C2/C 10.38% 1.25 1.499999 B3/B8.88% 1.5 1.749999 B2/B 8.13% 1.75 1.999999 B1/B+ 7.13% 2 2.2499999 Ba2/BB 5.63% 2.25 2.49999 Ba1/BB+ 4.63% 2.5 2.999999 Baa2/BBB 3.63% 3 4.249999 A3/A2.93% 4.25 5.499999 A2/A 2.63% 5.5 6.499999 A1/A+ 2.48% 6.5 8.499999 Aa2/AA 2.33% 8.50 100000 Aaa/AAA 2.03% Drop in EBITDA 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Drivers of the optimal debt ratio Marginal tax rate = 17.10% EBITDA/ Firm value = 3.83% EBIT/ Firm value = 2.96% Unlevered beta = 0.80 $1,746 $397 17.10% $270 $119 Implied Growth Rate Calculation Value of Firm$45,798 Current WAC6.13% Current FCFF$1,244.98 ! I am ignoring working capital Implied Grow3.32% If this number is >your riskfree rate, I use the riskfree rate as a perpetual growth rate. Ratings comparison at current debt ratio Current Interest coverage ratio = 11.37 Rating based upon coverage = Aaa/AAA Interest rate based upon coverage = 2.03% Current rating for company = Baa1 Current interest rate on debt = 4.63% Drop in operating income based on curre 0.00% Current Depreciation= Current Interest rate (Com Current T.Bond rate= $397 4.63% 1.63% EREST RATES 70.00% 233.33% $32,059 Err:522 Err:522 Err:522 Err:522 $397 80.00% 400.00% $36,639 Err:522 Err:522 Err:522 Err:522 $397 90.00% 900.00% $41,218 Err:522 Err:522 Err:522 Err:522 $397 Err:522 #REF! Err:522 #REF! Err:522 $397 Err:522 Err:522 #REF! Err:522 #REF! Err:522 $397 Err:522 Err:522 #REF! Err:522 #REF! Err:522 $397 Err:522 Err:522 Err:522 #REF! #REF! Err:522 Err:522 Err:522 #REF! #REF! Err:522 Err:522 Err:522 #REF! #REF! Err:522 70.00% 233.33% $32,059 Err:522 Err:522 Err:522 0 #REF! 80.00% 400.00% $36,639 Err:522 Err:522 Err:522 0 #REF! 90.00% 900.00% $41,218 Err:522 Err:522 Err:522 0 #REF! Debt Ratio 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Beta 0.80 #REF! #REF! #REF! #REF! #REF! #REF! #REF! #REF! #REF! Cost of Equity Bond RatingInterest rate on debt Tax Rate Cost of Debt (after-tax) 6.02% Aaa/AAA 2.03% 17.10% 1.68% #REF! #REF! #REF! #REF! #VALUE! #REF! #REF! #REF! #REF! #VALUE! #REF! #REF! #REF! #REF! #VALUE! #REF! #REF! #REF! #REF! #VALUE! #REF! #REF! #REF! #REF! #VALUE! #REF! #REF! #REF! #REF! #VALUE! #REF! #REF! #REF! #REF! #VALUE! #REF! #REF! #REF! #REF! #VALUE! #REF! #REF! #REF! #REF! #VALUE! WACC Firm Value (G) 6.02% $46,904 #VALUE! #REF! #VALUE! #REF! #VALUE! #REF! #VALUE! #REF! #VALUE! #REF! #VALUE! #REF! #VALUE! #REF! #VALUE! #REF! #VALUE! #REF! Rating is Aaa/AAA Aa2/AA A1/A+ A2/A A3/ABaa2/BBB Ba1/BB+ Ba2/BB B1/B+ B2/B B3/BCaa/CCC Ca2/CC C2/C D2/D Not rated Rating is D2/D Caa/CCC Ca2/CC C2/C B3/BB2/B B1/B+ Ba2/BB Ba1/BB+ Baa2/BBB A3/AA2/A A1/A+ Aa2/AA Aaa/AAA Yes/No Yes No Low IBC -30% -25% -25% -25% -15% -10% -10% -10% -10% -5% 0.00% 0.00% 0.00% 0.00% 0% Medium -50.00% -40.00% -40.00% -40.00% -25.00% -20.00% -20.00% -20.00% -20.00% -10.00% -2.00% 0.00% 0.00% 0.00% 0.00% High IBC -100% -50% -50% -50% -30% -25% -25% -25% -25% -15% -5% -2% 0% 0% 0% IBC High Medium Low Type of firm 1 2