OCS Project - Microsoft
determine the optimum capital structure.
- "Sample Combination WACC and OCS Spread Sheet" as a model.
- What was the existing capital structure for your firm? Do you believe it was optimum?
- Hamada's equation to determine the optimum.
- Should your company take on more debt, repurchase stock, have a seasoned equity offering? Justify your answers
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) Data From: Tax rate 11% Debt (D) $74,243,000,000.00 Number of shares (n) 7,753,000,000 Stock price per share (P) $151.38 Capital Structure (Millions Except Per Share Data) Market value of equity (S = P x n) $1, 173,649, 140,000.00 Total value (V = D + S) $1,247,892, 140,000.00 Percent financed with debt (Wa = DMV) 5.9% Percent financed with stock (W= = SM) 14.1% Cost of Capital Data From Cost of debt (ra) 5.73% Beta (b) 1.08 Risk-free rate (RF) 4.00% Market risk premium (RPM) .50% Cost of equity ([s = [RF + b x RPM ) 9.94% Cost of Equity from Dividend Growth Model Future Dividend Growth Rate 0. 15% Last Dividend $ 0.3931 Share Price $ (4/5/13) 151.38 Cost of Equity from Dividend Growth Model 0.41% Cost of Equity from Bond Plus Markup Cost of debt 5.73% Risk Markup 7.14% Cost of Equity from Bond Plus Markup 12.87% Average rs 7.7% WACC 7.58% ESTIMATING THE OPTIMAL CAPITAL STRUCTURE Estimating Optimal Capital Structure (Millions of Dollars) Percent of Firm Financed with Debt (Wa) 10% 15% 20% 25% 30% 35% 40% Ws 90.00% 85.00% 30.00% 75.00% 70.00% 55.00% 60.00% 2.80% 3.00% 3.26% 3.50% 4.00% 5.00% 5.75% b 1.12 1.18 1.25 1.33 141 1.51 1.63 10.18% 10.51% 10.87% 11.29% 11.77% 12.32% 12.96% 15. ra (1-T) 2.49% 2.67% 2.90% 3.12% 3.56% 4.45% 5.12% 6. WACC 9.41% 9.33% 9.28% 9.25% 9.31% 9.56% 9.82% Notes 1. The percent financed with equity is: Ws = 1 - Wa The interest rate on debt, ra, is obtained from investment bankers 3 The levered beta is estimated using Hamada's formula, and unlevered beta of bu = x and a tax rate of 11%: b = bu [1 + (1-T) (w /w=)]- 4. The cost of equity is estimated using the CAPM formula with a risk-free rate of 4% and a market risk premium of 5.50%: Is = [RF + (RPM)b 5. The after-tax cost of debt is ra (1-T), where T = 39%. I he weighted average cost of capital is calculated as: WACC = Ws Is + Wa ra (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(w /w,)] bu = b / [1 + (1-T) x (w /w,)] 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 1.08 Current Wa 6% Current Ws 94% Tax rate 11% 1 0224 As shown above, beta rises with financial leverage. With beta specified, we can determine the effects of leverage on the cost of equity
