The firm is IBM

Effects of Recapitalization on the Firm's Bond Rating and Cost of Debt You will try to estimate the effect of the proposed change of leverage on the firm's bond rating. You should use the regression model in Handout #20 based on the work of Bloom, Lim and McKinlay (BLM). This is described in Handout #18, on pages 1-4. You need not estimate the regression yourself, you will use the parameters provided in the handout On the Bloomberg terminal you can find the current S&P rating of the firm's debt. You probobly collected this with the data on the firm's debt earlier. First, use the BLM model to estimate the hypothetical rating for the bonds of the firm as currently levered You will need to compute (1) the logarithm of firm size (in SM), (2) the coverage ratio, (3) the total-debt- to-asset ratio, and (4) the ROA. The hypothetical rating that you calculate using the regression model may differ from the actual. You will need to know this to adequately judge the effect of the recapitalization on the rating and required yield on debt Next, you will use the figures from Homework #6, where you estimate income statements and (book value) balance sheets for the recapitalized firm, to calculate the ratios (described above) at the new capital structure. These are then substituted into the BLM model to see the effect of the recapitalization on the bond rating. Remember that the income statements that you have estimated are based on the assumption that the firm will issue the new debt as ten-year bonds Then, comes the most interesting part. You should think about whether the recapitalization may substantially raise the firm's cost of debt financing. For instance, if the firm's current rating is BBB, and you think that the recapitalization would drop their rating by three notches (to BB), what would happen to the yield on the firms outstanding debt? This is clearly not an exact science, but requires some sound judgment on your part. I would suggest that you use the Curve Finder (CRVF) on the Bloomberg Terminal to plot the current yield for your firm's debt (along the yield curve) with those for bond indices of ratings that your firm might slip into following the recapitalization. If your firm's curve is not available on the CRVF, you will have to use the information on the yields of the bonds that you have already collected. In Handout #18 I also supply the most current data using the CMX1 function from the Bloomberg Terminal on the yields of bonds of different ratings and maturities. You need to consider not only the yield that the new bonds will bear, but also about the firm's existing debt; in this case it is useful to know the weighted- average maturity of the firm's outstanding bonds. For the analysis of the effect of the recapitalization on debt, prepare a brief summary explaining what you feel will happen to your firm's bond rating and borrowing costs on new debt funding and the existing securities if they double the amount to long-term debt on the balance sheet. This is not a formal memorandum. Just a few sentences, so that I can check your reasoning against your empirical results. Effects of Recapitalization on the Firm's Beta and Cost of Equity I also want to be sure that you wil be able to estimate the required return on equity for the recapitalized firm. In estimating the WACC in Homework #4A you decided on a base estimate of Beta for your firm. You will use the Hamada Formula to examine the effect of the change in leverage on the firm's Beta. This method is described in Handout #8. You will also need data from the current and relevered (market value) balance sheets from Homework #6 for this part of the assignment. First, use the values of debt and equity from the current balance sheet to calculate the unlevered beta; this is an intermediate step. Be sure to include all the debt accounts when finding the value of firm debt. Then, use the figures for the relevered case, to estimate the firm's Beta with the new higher level of debt that you estimated on Homework #6. Recall that the Hamada Formula is based on the Market Values of the Debu/Equity Ratio. In Homework #4A you chose some parameters to use in the Capital Asset Pricing Model (CAPM), risk-free rate and market premium. Use these, and the current Beta to estimate the required return on equity for the firm as currently levered. Then, use the new estimate of the relevered Beta to estimate the required return after the increase in leverage using these same parameters. Effects of Recapitalization on the Firm's Bond Rating and Cost of Debt You will try to estimate the effect of the proposed change of leverage on the firm's bond rating. You should use the regression model in Handout #20 based on the work of Bloom, Lim and McKinlay (BLM). This is described in Handout #18, on pages 1-4. You need not estimate the regression yourself, you will use the parameters provided in the handout On the Bloomberg terminal you can find the current S&P rating of the firm's debt. You probobly collected this with the data on the firm's debt earlier. First, use the BLM model to estimate the hypothetical rating for the bonds of the firm as currently levered You will need to compute (1) the logarithm of firm size (in SM), (2) the coverage ratio, (3) the total-debt- to-asset ratio, and (4) the ROA. The hypothetical rating that you calculate using the regression model may differ from the actual. You will need to know this to adequately judge the effect of the recapitalization on the rating and required yield on debt Next, you will use the figures from Homework #6, where you estimate income statements and (book value) balance sheets for the recapitalized firm, to calculate the ratios (described above) at the new capital structure. These are then substituted into the BLM model to see the effect of the recapitalization on the bond rating. Remember that the income statements that you have estimated are based on the assumption that the firm will issue the new debt as ten-year bonds Then, comes the most interesting part. You should think about whether the recapitalization may substantially raise the firm's cost of debt financing. For instance, if the firm's current rating is BBB, and you think that the recapitalization would drop their rating by three notches (to BB), what would happen to the yield on the firms outstanding debt? This is clearly not an exact science, but requires some sound judgment on your part. I would suggest that you use the Curve Finder (CRVF) on the Bloomberg Terminal to plot the current yield for your firm's debt (along the yield curve) with those for bond indices of ratings that your firm might slip into following the recapitalization. If your firm's curve is not available on the CRVF, you will have to use the information on the yields of the bonds that you have already collected. In Handout #18 I also supply the most current data using the CMX1 function from the Bloomberg Terminal on the yields of bonds of different ratings and maturities. You need to consider not only the yield that the new bonds will bear, but also about the firm's existing debt; in this case it is useful to know the weighted- average maturity of the firm's outstanding bonds. For the analysis of the effect of the recapitalization on debt, prepare a brief summary explaining what you feel will happen to your firm's bond rating and borrowing costs on new debt funding and the existing securities if they double the amount to long-term debt on the balance sheet. This is not a formal memorandum. Just a few sentences, so that I can check your reasoning against your empirical results. Effects of Recapitalization on the Firm's Beta and Cost of Equity I also want to be sure that you wil be able to estimate the required return on equity for the recapitalized firm. In estimating the WACC in Homework #4A you decided on a base estimate of Beta for your firm. You will use the Hamada Formula to examine the effect of the change in leverage on the firm's Beta. This method is described in Handout #8. You will also need data from the current and relevered (market value) balance sheets from Homework #6 for this part of the assignment. First, use the values of debt and equity from the current balance sheet to calculate the unlevered beta; this is an intermediate step. Be sure to include all the debt accounts when finding the value of firm debt. Then, use the figures for the relevered case, to estimate the firm's Beta with the new higher level of debt that you estimated on Homework #6. Recall that the Hamada Formula is based on the Market Values of the Debu/Equity Ratio. In Homework #4A you chose some parameters to use in the Capital Asset Pricing Model (CAPM), risk-free rate and market premium. Use these, and the current Beta to estimate the required return on equity for the firm as currently levered. Then, use the new estimate of the relevered Beta to estimate the required return after the increase in leverage using these same parameters