determine what the optimum capital structure is for your firm. A sample spreadsheet is provided where you may input the data that you have already found for the WACC. The spreadsheet will use Hamada?s Equation to recalculate the levered betas based on the weights that you choose.

NOTE: You cannot just assume that your weights and your bond values are the same as the sample. You must choose the appropriate weights first based on the market value weights your firm currently has. Then, you must choose appropriate bond rates as you increase or decrease the weight for debt.

You must explain and reference how you chose your numbers and attach a copy of the spreadsheet.

Attached is the WACC project and sample spreadsheet

Complete the OCS project according to the assignment instructions. For example:

• Complete a table similar to Figure 15-5 in the textbook (see attached)
• Use the "Sample Combination WACC and OCS Spread Sheet" as a model
• Your table will likely not be identical since it depends on what your capital structure is now
• What was the existing capital structure for your firm? Do you believe it was optimum?
• Use Hamada?s equation to determine the optimum
• Should your company take on more debt, repurchase stock, have a seasoned equity offering? Justify your answers

As per the CAPM model for Amazon.com Inc., the Re of the stock = Rf + (Rm-Rf) Hence, Re = 3.6 + (11-3.6)0.43 = 6.782% = 0.43 (http://finance.yahoo.com/q?s=MO) [Beta] Rf = 3.6% [risk free rate] Rm = 11% [Market expected return] Dividend History Dividend Summary for Amazon.com Inc. Security: MO (Common Stock). Please note that dividend amounts have been readjusted to reflect prior stock splits. 2012 Declared Ex-Date Record Payable Amount Type 12/12/2012 12/21/2012 12/26/2012 01/13/2013 $0.440 Regular Cash 08/24/2012 09/12/2012 09/14/2012 10/10/2012 $0.440 Regular Cash 05/17/2012 06/13/2012 06/15/2012 07/10/2012 $0.410 Regular Cash 03/01/2012 03/13/2012 03/15/2012 04/10/2012 $0.410 Regular Cash 2011 Declared Ex-Date Record Payable Amount Type 12/14/2011 12/22/2011 12/27/2011 01/10/2012 $0.410 Regular Cash 08/26/2011 09/13/2011 09/15/2011 10/11/2011 $0.410 Regular Cash 05/19/2011 06/13/2011 06/15/2011 07/11/2011 $0.380 Regular Cash 02/24/2011 03/11/2011 03/15/2011 04/11/2011 $0.380 Regular Cash Declared Ex-Date Record Payable Amount Type 12/15/2010 12/23/2010 12/28/2010 01/10/2011 $0.380 Regular Cash 08/27/2010 09/13/2010 09/15/2010 10/12/2010 $0.380 Regular Cash 05/20/2010 06/11/2010 06/15/2010 07/09/2010 $0.350 Regular Cash 02/24/2010 03/11/2010 03/15/2010 04/09/2010 $0.350 Regular Cash 2010 As per, http://investor.altria.com/phoenix.zhtml?c=80855&p=irol-stockanddividendinfo Hence Dividend Payments (annual) in: 2012 = $1.7 ; 2011 = $1.58 ; 2010 = $1.46 Putting time value of money in dividend of 2011 and 2010, Dividend in today's real terms would had been For 2011 = 1.58 (1.06782) = 1.687 For 2010 = 1.46 (1.06782)^2 = 1.665 Dividend growth (from 2010 to 2011) = (1.687-1.665)/1.665 = 1.32% Dividend growth (from 2011 to 2012) = (1.7 - 1.687)/1.687 = 0.77% Average dividend growth = 1.0132 x 1.0077 = 1.04% Hence as per Gordon's Dividend Forecast model, we hereby use the following formula to arrive at the intrinsic value of the stock = D1 R e g Where D1 Re D 0 (1+ g) = Expected Dividends one year from now (next period) i.e. = Required rate of return for equity investors g = Growth rate in dividends forever Hence value of the stock = 1.7(1+0.014)/(0.06782-0.0104) = 1.7238/0.05742 = $30.02 Closing Price of the stock on the year end = $31.44 (http://investor.altria.com/phoenix.zhtml?c=80855&p=irolstockLookup&t=HistQuote&control_firstdatereturned=&src=leftnav) Hence, the stock is trading rich and the investors should go short. Buying the stock would not be a good option. Note: Opinion subject to last fiscal year end data, i.e. 31st Dec 2012. Free Cash Flow Technique In thousands Period Ending Net Income Dec 30, 2012 Dec 30, 2011 4,180,000 3,390,000 Dec 30, 2010 3,905,000 Operating Activities, Cash Flows Provided By or Used In Depreciation 225,000 Adjustments To Net Income (71,000) Changes In Accounts Receivables 202,000 Changes In Liabilities 612,000 Changes In Inventories 33,000 Changes In Other Operating Activities (1,281,000) Total Cash Flow From Operating Activities 3,903,000 253,000 188,000 (19,000) 89,000 24,000 (315,000) 3,613,000 276,000 (1,050,000) 15,000 (176,000) 7,000 (212,000) 2,767,000 Data Source: (http://finance.yahoo.com/q/cf?s=MO+Cash+Flow&annual) Growth Rate from Previous year Average Growth Rate = 7.43% 23.41% 1.07431.2341 = 15.14% WACC Long term Debt = $12,419mill Stock holders Equity (Only Common Stock) Common Stock Retained Earnings Stockholders Equity $'000 935,000 24,316,000 25,251,000 Since there is no target ratio mentioned, the current weightage itself can be assumed to be the target weights. For calculation convenience, lets takes the Debt to Equity as 1:2 Re = 6.782% and debt = 0% (http://finance.yahoo.com/q/is? s=MO+Income+Statement&annual) , from the mentioned data source it is clear that the group has no interest expense and hence it can be assumed that it has debts freely available t zero rate of interest. Hence, WACC = We X Re = 0.66 X 0.06782 = 0.045 or 4.5% During the explicit forecast period, Cash flows for the years 2013, 2014, 2015 would be computed as follows = [FCFF x (1+g)^n] FCFF = Free Cash flow g = growth rate of the cash flows n = the number of years (from the last fiscal year 2012) Hence, for 2013 = $3903m x 1.1541 = $4504,450 (PV = 4310) Similarly, for 2014 = $5198,590 (PV = 4760) For 2015 = $5999,700 (PV = 5258) Thereon for terminal period at T = 3, PV of all the cash flows from 2016 and onwards would be computed in a similar manner as that of the Gordon's model, except the fact that here, in this approach we would be using the free cash flows expected out of the business as instead of the dividends paid out of the business. = 5999,700 (1.05)/[0.06782-0.05] = $353,535,000 Terminal value would not be computed if the cost of capital would be as low as 4.5% since the growth rate itself is 5%, hence it is assumed at year end 3 the company would pay off its debt fully and have only common stock remaining. Total Net Worth of the group company (as per the above calculation) = 4310 + 4760 + 5258 + 353535 = $367,863,000 Hence Value of Equity = 367863 - 12419(debt) = $355,444,000 Volume of shares = 9627300 Hence, Share Value as per FCF Valuation = 355,444,000/9627300 = $36.92 Market Price (as mentioned earlier) = $31.44 Hence for venturers this would be a good acquisition as with better management and their own governance the company seems to have a positive impact on the expected performance. The intrinsic value expected is arriving at $36.92 which is higher than the current price of $31.44 hence this acquisition will result in appreciation of shareholders wealth. As far as policy suggestions are concerned, possibilities in the FCF approach are huge since every policy will have a unique impact on the price of the stock. Once the ownership changes, it depends on the new venturers to run the business. But in case of dividend policy we may consider a few factors, most important being the return on equity provided by the company over the expected return of the shareholders. Re = 6.782% as computed above. ROE = Net income/ Shareholders Equity = 4180/25251 = 16.55% Hence the company is earning much higher than the market would at the Beta level of risk in which Amazon.com is operating. A 100% retention policy would be suggested. Investing Activities, Cash Flows Provided By or Used In Capital Expenditures (124,000) Investments 1,049,000 Other Cash flows from Investing Activities (5,000) (105,000) 490,000 2,000 (168,000) 312,000 115,000 Total Cash Flows From Investing Activities 387,000 259,000 (3,222,000) (1,322,000) 1,494,000 6,000 (2,958,000) 98,000 232,000 45,000 (5,193,000) (3,044,000) (2,583,000) 920,000 Financing Activities, Cash Flows Provided By or Used In Dividends Paid (3,400,000) Sale Purchase of Stock (1,104,000) Net Borrowings 187,000 Other Cash Flows from Financing Activities (876,000) Total Cash Flows From Financing Activities The company should aim at buying a larger portion of the stock back, as we observed above the Amazon.com has debts for which it is not required to pay any interest expense. If this is possible it would be advisable to for debts and this would concentrate the profits in the hands of the fewer ones. Dividend payments should be avoided. Capital Expenditure and investment requirements should be met by taking loan rather than issuing shares. This will create shareholder's wealth. Even if we somehow account for contingencies, the debt would still be beneficial as there are always Government regulations which would not allow a sudden hike in the interest rate all of a sudden. And further there would always be an interest tax shield available to the Group if they opt for debt rather than equity. Tool Kit for Capital Structure Decisions Optimum Capital Structure Problem (Millions of Dollars Except Per Share Data) NUMBERS IN RED MUST BE INPUTTED, NUMBERS IN BLUE ARE CALCULATED Input Data (Millions Except Per Share Data) Tax rate Debt (D) Number of shares (n) Stock price per share (P) 39% $2,119,560,000.00 728,100,000 $12.81 Capital Structure (Millions Except Per Share Data) Market value of equity (S = P n) Total value (V = D + S) Percent financed with debt (wd = D/V) Percent financed with stock (ws = S/V) Data From: $9,326,961,000.00 $11,446,521,000.00 18.5% 81.5% Cost of Capital Cost of debt (rd) Beta (b) Risk-free rate (rRF) Market risk premium (RPM) Cost of equity (rs = rRF + b RPM ) 3.26% 1.14 2.87% 6.54% 10.31% Cost of Equity from Dividend Growth Model Future Dividend Growth Rate Last Dividend $ Share Price $ (4/5/13) 10.60% 0.0345 12.81 $ Cost of Equity from Dividend Growth Model Data From 10.90% Cost of Equity from Bond Plus Markup Cost of debt Risk Markup Cost of Equity from Bond Plus Markup 3.26% 7.20% 10.46% 10.6% Average rs WACC 8.97% ESTIMATING THE OPTIMAL CAPITAL STRUCTURE The optimal capital structure is the one that maximizes the value of the company. Also, that same capital structure minimizes the WACC. We begin by estimating how capital structure affects the costs of debt and equity. The effects on debt are usually estimated by talking with bankers and investment bankers. Discussions with its bankers indicate that Strasburg can borrow different amounts, but the more it borrows, the higher the cost of its debt. Note: the percentages are based on market values. Estimating Optimal Capital Structure (Millions of Dollars) Percent of Firm Financed with Debt (wd) 10% 1. 2. 3. 4. 5. 6. ws rd b rs rd (1T) WACC Notes: 90.00% 2.80% 1.07 9.85% 1.71% 9.04% 15% 85.00% 3.00% 1.11 10.11% 1.83% 8.87% 20% 80.00% 3.26% 1.15 10.41% 1.99% 8.72% 25% 75.00% 3.50% 1.20 10.74% 2.14% 8.59% 30% 70.00% 4.00% 1.26 11.12% 2.44% 8.51% 35% 65.00% 5.00% 1.33 11.56% 3.05% 8.58% 40% 60.00% 5.75% 1.41 12.07% 3.51% 8.64% 1. The percent financed with equity is: ws = 1 wd 2. The interest rate on debt, rd, is obtained from investment bankers. 3. The levered beta is estimated using Hamada's formula, and unlevered beta of b U = x and a tax rate of 39%: b = bU [1 + (1-T) (wd/ws)]. 4. The cost of equity is estimated using the CAPM formula with a risk-free rate of 2.87% and a market risk premium of 6.54%: r s = rRF + (RPM)b. 5. The after-tax cost of debt is rd (1T), where T = 39%. 6. The weighted average cost of capital is calculated as: WACC = ws rs + wd rd (1-T). THE HAMADA EQUATION Hamada developed his equation by merging the CAPM with the Modigliani-Miller model. We use the model to determine beta at different amount of financial leverage, and then use the betas associated with different debt ratios to find the cost of equity associated with those debt ratios. Here is the Hamada equation: b = bU x [1 + (1-T) x (D/S)] b = bU x [1 + (1-T) x (wd/ws)] bU = b / [1 + (1-T) x (wd/ws)] Here b is the leveraged beta, bU is the beta that the firm would have if it used no debt, T is the marginal tax rate, D is the market value of the debt, and S is the market value of the equity. Levered beta, b Current wd Current ws Tax rate bU 1.14 19% 81% 39% 1.0012 As shown above, beta rises with financial leverage. With beta specified, we can determine the effects of leverage on the cost of equity