Part 1

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 she is not 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 aver-age 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:

1. the firm issues $5 billion in new debt to repurchase stock, and

2. the firm issues $5 billion in new stock to repurchase debt.

Use Excel to answer the following questions using Eqs. 14.5 and 14.6, and assuming a cost of unlevered equity (rU) of 12%.

Use Excel to answer the following questions using Eqs. 14.5 and 14.6, and assuming a cost of unlevered equity (rU) of 12%.

Cost of Capital of Levered Equity (14.5)

rE= rU+DE(rU- rD)

Unlevered Cost of Capital (14.6)

rU= EE+DrE+DE+DrD

Number of shares outstanding, price of equity and cost of debt are provided in the worksheet.

1. Compute the market D/E ratio for Home Depot. Approximate the market value of debt by the book value of net debt; include both Long-Term Debt and Short-Term Debt/Current Portion of Long-Term Debt from the balance sheet and subtract any cash holdings. Use the stock price and number of shares outstanding to calculate the market value of equity.

2. Compute the cost of levered equity (rE) for Home Depot using their current market debt-to-equity ratio and Eq. 14.5.

3. Compute the current weighted average cost of capital (WACC) for Home Depot using Eq. 14.6 given their current debt-to-equity ratio.

4. Repeat Steps 3 and 4 for the two scenarios you would like to analyze, issuing $5 billion in debt to repurchase stock, and issuing $5 billion in stock to repurchase debt. (Although you realize that the cost of debt capital rD may change with changes in leverage, for these modestly small changes you decide to assume that rD remains constant. What is the market D/E ratio in each of these cases?

Part 2

Your boss was impressed with your presentation regarding the irrelevance of capital structure, but, as expected, has realized that market imperfections like taxes must be accounted for.

You have now been asked to include taxes in your analysis. Your boss knows that interest is deductible and has decided that the stock price of Home Depot should increase if the firm increases its use of debt. Thus, your boss wants to propose a publicly announced share repurchase program (a tender offer) using the proceeds from a new debt issue and wants to present this plan to the CEO and perhaps to the Board of Directors.

Your boss would like you to examine the impact of two different scenarios, adding a relatively modest level of debt and adding a higher level of debt. In particular, your boss would like to consider issuing $5 billion in new debt or $10 billion in new debt. In either case, Home Depot would use the proceeds to repurchase stock.

For all future projections, use a corporate tax rate of 21%.

1. Begin by analyzing the scenario with $5 billion in new debt. Assuming the firm plans to keep this new debt outstanding forever, determine the present value of the tax shield of the new debt.

2. Determine the new stock price if the $5 billion in debt is used to repurchase stock.

a. Use the current market value of Home Depots equity that you calculated in Part 1.

b. Determine the new market value of the equity if the repurchase occurs.

c. Determine the new number of shares and the stock price after the repurchase is announced.

3. (4 points) What will Home Depots market value D/E ratio be?

4. Repeat Steps 24 for the scenario in which Home Depot issues $10 billion in debt and repurchases stock.

Submission link: Report your results by choosing the options presented in the following multiple-choice questions

1. Part 1. The market D/E ratio, rE and WACC for Home Depot prior to stock and debt repurchases are closest to:

[A] 13.9%; 14.1%; 12%

[B] 12.5%; 12.8%; 12%

[C] 10.9%; 13.0%; 12%

[D] 12.9%; 13%; 12.5%

2. Part 1. The rE and WACC increasing debt by $5 billion by reducing equity by 5 billion are clsest to:

[A] 13.2%; 12%

[B] 12.9%; 13%

[C] 13.9%; 14.7%

[D] 11.4%; 12.9%

3. Part 1. The rE and WACC after equity increased by 5 billion and debt is decreased by 5 billion are closest to:

[A] 13%; 11.8%

[B] 11.9%; 12%

[C] 12.7%; 12%

[D] 13.1%; 13.7%

4. Part 2. The present values of the tax shields of $5 billion and $10 billion new debt (in billion) respectively are closest to:

[A] $1.03; $2.0

[B] $1.05; $2.6

[C] $1.08; $3.0

[D] $1.05; $2.1

5. Part 2. The new stock prices if the $5 billion and $10 billion in debt respectively are used to repurchase stock are closest to::

[A] $201.3; $191.6

[B] $185.9; $186.9

[C] $171.4; $183.9

[D] $197.3; $ 201.2

6. Part 2. The Home Depots D/E ratios after it issues new debt and repurchases stock for $5 billion and $10 billion respectively are closest to :

[A] 10.1%; 12.5%

[B] 14.8%; 16.1%

[C] 17.4%; 21.2%

[D] 13.6%; 16.3%