To estimate the optimal mix of debt and equity for your firm and to evaluate the effect on

firm value of moving to that mix.

KEY STEPS

$1.$ Based on the cost of capital approach, estimate the optimal debt ratio for the firm and

examine how sensitive it is to your operating income assumptions.

$2.$ Validate your conclusions using other approaches $($adjusted present value method$)$ to

estimating the optimal mix.

$3.$ Bringing in reasonable constraints into the decision process, estimate the optimal debt

ratio that you would recommend for the firm.

$4.$ Evaluate how much your firm has borrowed, relative to other firms in the sector and in

the market.

FRAMEWORK FOR ANALYSIS

$1.$ INTRINSIC APPROACHES

a$.$ As a starting point, estimate the current debt ratio for the firm and the cost of capital at

that debt ratio.

b$.$ Estimate your costs of debt, equity and capital as your debt ratio changes in the firm. That

will require you to estimate the beta and synthetic rating at each debt ratio.

c$.$ Examine how the optimal debt ratio changes, as you change key inputs into the analysis

$($both micro and macro$),$ keeping in mind the volatility of earnings in your company$$s

history and the sector that it operates in$.$ You may also want to incorporate indirect

bankruptcy costs into your assessments.

d$.$ Use the adjusted present value approach, where you consider the tax benefits from

debt and weigh them off against expected bankruptcy costs. Compare the optimal debt

ratio that you get, using this approach, to the one that you get with the cost of capital

approach.

e$.$ Make a judgment on your $$optimal$$ debt ratio.

$$ In making this judgment, you can start with your cost of capital assessments but

you should also consider whether the payoff from moving to the optimal justifies

the risk in doing so$.$

$$ Also, estimate the value of the business and the per share value, if you move to

the optimal.

DETAILED GUIDANCE ON HOW TO COMPLETE THE INTRINSIC APPROACH

COST OF CAPITAL APPROACH

$1.$ Estimate the firm$$s levered beta $($based on its current capital structure$)$ by regressing the

firm$$s weekly returns against the market$$s weekly returns.

$2.$ Compute the unlevered beta.

$3.$ Compute the levered beta at different D$/$E ratios.

$4.$ Compute the cost of equity at each D$/$E ratios $($using levered beta in step $3).$

$5.$ Estimate the cost of debt at different D$/$E ratios:

a$.$ Compute the Times Interest Earned $($TIE$)$ or interest coverage ratio for each level

of debt. Use the synthetic bond rating to determine the default spread and hence

the interest rates based on the TIE ratio. This may require more than one iteration

as the interest expense depends on the spread and the spread is dependent on the

TIE ratio. See power point on the cost of capital $($Damodaran$).$ The risk premium

for Jamaica is $11\mathrm{.}18\%.$

b$.$ Interest expense is tax deductible only up to the amount of the EBIT.

i$.$ Compute the maximum tax benefit: EBIT x Tax Rate $=$

ii$.$ Adjusted tax rate $=$

$3|$ P a g e

c$.$ Compute the after$-$tax cost of debt using interest rates computed in $($a$)$ and tax rate

computed in $($b$).$

$6.$ Compute the firms cost of capital at different debt levels using cost of equity from step $4$

and after$-$tax cost of debt in step $5.$

$7.$ Compute the current market value of the firm $($MVE$)$: MVE $=$ market value of the equity

$+$ market value of the debt $($use book value of debt if market value is not available$).$

$8.$ Assuming the constant growth model and the firm$$s current cost of capital, compute the

implied growth rate in FCF$.$

$9.$ Assume that all the increase in value is captured by the shareholders, what is the increase

in share price if the firm moves to the optimal debt level by recapitalization?

$2.$ RELATIVE ANALYSIS

a$.$ Relative to the industry to which this firm belongs, evaluate whether your firm has too

much or too little in debt. Do a sector regression, if necessary, to make this judgment.

b$.$ Relative to the market, evaluate whether your firm has too much or too little in debt. Do a

sector regression, if necessary, to make this judgment.

$3.$ SENSITIVITY ANALYSIS OPTIMAL DEBT RATIO IS A FUNCTION OF INTERNAL AND

EXTERNAL FACTORS.

$1.$ How will the optimal debt ratio change if tax rate is $33(1)/(3)\%.$

$2.$ How will the optimal debt ratio change if market interest rates increased by $5\%(500$

basis points$)?$

$4.$ CONCLUSIONS AND RECOMMENDATIONS

$1.$ Based on your computations and your sensitivity analyses recommend the optimal capital

structure $($one that maximizes firm value or minimizes cost of capital$).$

$2.$ Justify your recommendations.