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?