- What is Garmin's cost of capital as the summer of 2019 approaches?
- Calculate the missing numbers in the first panel(Scenario 1) of Exhibit 2. This includes the levered betas, cost of equity, and cost of capital at each debt ratio. What are the takeaways?
- Calculate the missing numbers in the second panel(Scenario 2) of Exhibit 2. This includes the levered betas, cost of equity, and cost of capital at each debt ratio. What are the takeaways?
- Calculate the missing numbers in the third panel(Scenario 3) of Exhibit 2. This includes the levered betas, cost of equity, and cost of capital at each debt ratio. What are the takeaways?
- Given Scenario 3 what would you advise Gamin's CFO to do about the capital structure?
- Can you provide variables not considered in the analysis that may be relevant? Can you adjust any of your calculations to account for these variables?
Optimizing a company's capital structure involves two steps: First, Identifying the financial instruments that should be used; and second, determining the proportions in which they should be used. Each source of finanding has a cost for the company, which is the other side of the coin of the retum required by investors. The cost of capital is nothing but the weighted average of those costs. An optimal capital structure, by definition, is the combination of financial instruments that minimizes a company's cost of capital. Or, more formally in the case of a company that uses debt and equity, an optimal capital structure is given by the x0 and xf that minimize the company's Rwacc. 3. The Data Approaching the summer of 2019, Garmin did not have any long-term debt in its capital structure. That situation concerned Douglas Boessen, Garmin's CFO, because of the opportunities available for low-cost financing in the debt market. Since the financial crisis of 2008 , most central banks had been keeping interest rates at a very low level, a situation that many countries and companies took advantage of by issuing bonds at very convenient rates. Perhaps it was Garmin's turn to take advantage of that opportunity. Boessen thought he would consider, besides the current (unlevered) cap. structure, five alternatives for the company, ranging between 13% and 75% of debt, with the rest consisting of equity financing. (See Exhlbit 2) He also thought he would consider three scenarios for the cost of debt, although he did not think that all of them were equally plausible. In the first scenario, Garmin's bonds would have a constant yleld to maturity regardless of the company's leverage; in the other two scenarios, the cost of debt would increase with the companys leverage. At the time Boessen was considering this issue, the vield on 10-year U.S. Treasury notes stood at 2.3%, the market risk premium remained around its long-term historical estimate of 5\%; Garmin's beta with respect to the S\&P 500 was 12; and the company faced the statutory corporate tax rate of 21%. 4. The Work To Be Done The summer was tast approaching, and Boessen was determined ta make a decision on Garmin's capital structure betore leaving for vacation. This required a careful analysis of the cost of debt and equity, and therefore the cost of capital that would preval with different capital structures. Fortunately, Borssen had a fisst chass group of peopte teady to help him with this task \begin{tabular}{|c|c|c|c|c|c|c|} \hline \multicolumn{7}{|l|}{\begin{tabular}{l} Scenario 1 \\ Debt ratio \end{tabular}} \\ \hline Debt ratio & 0% & 15% & 30% & 45% & 60% & 75% \\ \hline Cost of debt & 3.0% & 3.0% & 3.0% & 3.0% & 3.0% & 3.0% \\ \hline Levered beta & ? & ? & ? & ? & ? & ? \\ \hline Cost of equity & ? & ? & ? & ? & ? & ? \\ \hline Cost of capital & ? & ? & ? & ? & ? & ? \\ \hline Scenario 2 & & & & & & A \\ \hline Debt ratio & 0% & 15% & 30% & 45% & 60% & 75% \\ \hline Cost of debt & 3.0% & 3.1% & 3.5% & 4.1% & 5.1% & 6.3% \\ \hline Levered beta & ? & ? & ? & ? & ? & ? \\ \hline Cost of equity & ? & ? & ? & ? & ? & ? \\ \hline Cost of capital & ? & ? & ? & ? & ? & ? \\ \hline \multicolumn{7}{|l|}{ Scenario 3} \\ \hline Debt ratio & 13% & 28% & 34% & .2% & 57% & 70% \\ \hline Cost of debt & 2.4% & 2.8% & 2.9% & 3.9% & 5.2% & 8.5% \\ \hline Levered beta & ? & ? & ? & ? & ? & ? \\ \hline Cost of equity & ? & ? & ? & ? & ? & ? \\ \hline Cost of capital & ? & ? & ? & ? & ? & ? \\ \hline \end{tabular} The roquired return on debt (or cost of debt) is usually assessed with a bond"s vield to maturity. which is the retum investors require to hold the bond until it expires. If a company has more than one bond outstanding the cost of debt is simply the weighted average of the vields to maturity of those bonds. Credit quality and bond yields are irversely retated; that is, the lower (higher) a company's credit rating is, the higher (lower) is its cost of debt. Unsurprisingly, the return required by investors for holding a company's bond increases with the risk of default they have to bear. The required retum on equity (or cost of equity) is typically, though not exclusively, estimated with the CAPM (Capital Asset Pricing Model), one of the modets most widely used by finance practitioners. This model is given by the expression Rr=Ry+MRP.6 where RE is the required return on equity; Ry is the risk-free rate; MRP is the market risk premium (or equity risk premium); and is a company's beta. The risk-free rate is basically the compensation required for the expected loss of purchasing power, which depends on the expected rate of inflation. The market risk premium is the compensation required for investing in relatively riskier equity as opposed to in relatively safer (government) debt. And beta measures the sensitivity of a company/s returns to fluctuations in the market; that is, a company with a beta higher (lower) than 1 tends to magnify (mitigate) the ups and downs of the market. Intuitively, the CAPM says the following: Equity imvestors demand a compensation for their expected loss of purchasing power (the risk-free rate), and an additional compensation for investing in equity rather than in debt (the market risk premium), taking into account whether the company in which they are investing tends to magnify or mitigate the market's fluctuations (beta). Put differently, equity investors demand a return as a compensation for bearing the risk of losing purchasing power and the (undiversifiable) risk of the company in which they invest. Formally, the cost of capital (Ruac) of a company financed with debt and equity is given by the expression Rwaxc=(1ti)x0+RD+xDRi where tc is the corporate tax rate; x0 (the debt ratio) and xc (the equity ratio) are the proportions of (long-term) debt and equity in the company's capital structure; and R0 and Rr are the required return on debt and equity. By definition, x0=D/(D+E) and x8=E/(D+E) where D and E denote (long-term) debt and equity, and, therefore, x0+xr=1. Both R0 and Rt are increasing in a company's leverage; in other words, the higher the proportion of debt in a company's capital structure, the higher both R0 and Rl tend to be. in the case of equity, this relationship can be formalized with the expression 2=1+(1t6)(D/E)+u where bi and B denote the levered and the unfevered beta, and D/E is a company's debt-equity ratio. An unlevered beta is the beta of a company fully financed with equity, and a levered beta is the beta of a company with debt in its capital structure. The summer of 2019 was fast approaching and Douglas Boessen, Garmin's CFO, was adamant that he would not leave for vacation before dealing with the long-postponed review of the company's capital structure. Garmin did not have any long-term debt and Boessen thought that given the environment of low interest rates, the company would benefit from tapping the bond market. This case is designed to assess Garmin's capital structure and discuss whether the company should add debt to it. 1. The Company Garmin was founded in 1989 in Lenexa, Kansas, under the name ProNav. The company later changed its name to Garmin, which is based on the names of its founders, Gary Burrell and Min Kao. Although it is largely known for its wearable technology for sport enthusiasts, Garmin specializes in GPS technology more broadly, operating through five segments, namely, auto, aviation, fitness, marine, and outdoor. Garmin is in the S\&P 500 index and trades in the Nasdaq. Its operations are ' 'adquartered in Olathe, Kansas, and its legal domicile is in Schaffhausen, Switzerland. In 2018, the company delivered almost 15 million products, reached a landmark 200 million products sold since inception, had sales of over $3.3 billion, and obtained profits of almost $700 million. (See Exhibit 1.) 2. A Brief Primer on Capital Structure A company's capital structure essentially refers to the combination of financial instruments used to finance its investment projects. Although typically thought of as debt and equity, a company's capital structure can have fewer than two instruments (for example, a company fully financed by equity) or more than two (for example a company financed by equity, debt, preferred equity, and convertible debt). Exhibit 1 Balance Sheet and Income Statement (Thousands of \$)
