You are on page 1of 17

PRELIMINARY STUFF AND INPUTS Objective Before you start Inputs Units Income inputs

Balance Sheet

Market Data

Tax Rate Default Spreads

READING THE OUTPUT Summary

Details References Corporate Finance: Theory and Practice, Chapter 18 Applied Corporate Finance: Chapter 8

PRELIMINARY STUFF AND INPUTS This spreadsheet allows you to compute the optimal capital structure for a non-financial service firm. If you have a financial service firm use capstrfin.xls Open preferences in excel, go into calculation options and put a check in the iteration box. If it is already checked, leave it as is. The inputs are primarily in the input sheet. If your company has operating leases, use the operating lease worksheet to enter your lease or rental commitments. Enter all numbers in the same units (000s, millions or even billions) The key income inputs are EBITDA, depreciation and amortization and interest expenses. Enter the most updated numbers you have for each (even if they are 12-month trailing numbers). If the most recent period for which you have data has an operating income that is abnormal, either because of extraordinary losses/gains or some other occurrence, use an average operating income over the last few years. From the statement of cash flows, also enter the capital spending from the recent period. P.S: If you have negative operating income and you expect to continue having negative operating income, your optimal debt ratio will be zero. Enter the book value of all interest-bearing debt. If you have a market value enter that number. Alternatively, input the average maturity of the debt and I will estimate the market value of debt. Enter the current stock price, the current long-term government bond rate, the risk premium you would like to use to estimate your cost of equity and the current rating for your firm. If you do not have a rating, there is an option for you at the very bottom of the spreadsheet to compute a synthetic rating. Enter a marginal tax rate, if you can estimate it. Otherwise, use the effective tax rate. This spreadsheet has interest coverage ratios, ratings and default spreads built into it in the worksheet. This spreadsheet treats the imputed interest expense on operating leases as part of the interest expense when computing the interest coverage ratio. You can choose between ratings for large firms (firms with market capitalizations that exceed $ 5 billion is a simple cut off but you can deviate from it) a more conservatve for small or risky firms. If you want, you can change the interest coverage ratios and ratings in these tables. READING THE OUTPUT The summary provides a picture of your firm's current cost of capital and debt ratio, and compares it to your firm's optimal debt ratio and the cost of capital at that level. It then uses the savings from the change in cost of capital to compute how much your firm value will change: - with constant savings: as the present value of a perpetuity - with a growth rate in the savings in perpetuity The firm value change, divided by the number of shares, yields a price change The details of the calculation at each debt ratio are below the summary.

orporate Finance: Theory and Practice, Chapter 18 plied Corporate Finance: Chapter 8

Question Q1: What do I do excel says there are circular references? Q2: My spreadsheet has gone crazy. I get errors all over. What did I do wrong? Q3: I am entering the inputs for my company but the optimal numbers do not seem to change from the originals Q4: I am getting an optimal debt ratio of 0%. This can't be right. Can it?

Q5: My cost of capital at my optimal debt ratio is higher than the current cost of capital. I thought it was supposed to be lower.

Answer Go into preferences, choose calculation options and make sure the iteration box has a check in it. I am sorry to say this, but you probably just made an input error. While you might have fixed it, the iterations in the spreadsheet make it very sensitive and the errors will not go away. The only fix (Sorry, sorry) is to copy the inputs into a fresh version of the spreadsheet. You probably forgot to check the iteration box (see Q1) change from the Sure. If your operating income is either negative or very low, relative to your firm value, you can end up at an optimal debt ratio of 0%. For instance, if you have EBIT of 100 on a firm value of 10000, a 10% debt ratio would probably push you into a C rating and give you a very high cost of capital. Generally, you are right. However, I would suggest that you look at three factors: - If your optimal is just slightly higher or lower than your current debt ratio, it is possible that you are closer to the optimal than the stated optimal. Let me explain. Assume that you are at a 24% debt ratio and the optimal comes out to 30%. The true optimal is really somewhere around 30% since I am constrained to work in 10% increments of the debt ratio. If the true optimal were 26%, your current debt ratio of 24% is closer to the optimal. - Rating Differences: One of the costs of rating a company based only on the interest coverage ratio is that the rating might be very different from the actual rating. Thus, your current cost of capital is based upon your current rating, and the optimal is based upon the synthetic ratings, and the two don't match, the current and the optimal cost of capital can be mismatched. You can get around this by switching to a synthetic rating for computing the current cost of capital (in the input sheet). - Existing debt at low rates: I assume in the spreadsheet that existing debt gets refinanced at the new pre-tax cost of debt at each debt ratio. Consequently, if you have a lot of old debt on your books at much lower rates, the interest expense that I report will be much higher than your actual interest expense. This, in turn, can affect your interest coverage ratio and rating. This, too, you can fix by locking in debt at current rates in the input sheet.

Inputs
Please enter the name of the company you are analyzing: Financial Information Earnings before interest, taxes and depreciation (EBITDA) Depreciation and Amortization: Capital Spending: Interest expense on debt: Tax rate on ordinary income: Current Rating on debt (if available): Interest rate based upon rating: Market Information Number of shares outstanding: Market price per share: Beta of the stock: Book value of debt: Can you estimate the market value of the outstanding debt? If so, enter the market value of debt: Do you want me to try and estimate market value of debt? If yes, enter the average maturity of outstanding debt? Do you have any operating leases? General Market Data Current long-term (LT) government bond rate: Risk premium (for use in the CAPM) General Data Which spread/ratio table would you like to use for your anlaysis? Do you want to assume that existing debt is refinanced at the 'new' rate? Do you want the firm's current rating to be adjusted to the synthetic rating? 1 Yes Yes (Yes or No) (Yes or No) 8.56% 2.80% (in percent) (in percent) Yes 5.00 Yes 379.753 $307.60 1.23 $72,960.80 No $25,426.10 $6,826.70 $13,895.50 $4,947.70 54.01% A9.56% Bharti Airtel

2.8

Operating Lease Converter

Operating lease expenses are really financial expenses, and should be treated as such. Accounting standards allow th be treated as operating expenses. This program will convert commitments to make operating leases into debt and adjust the operating income accordingly, by adding back the imputed interest expense on this debt.
Inputs Operating lease expense in current year = Operating Lease Commitments (From footnote to financials) Year Commitment ! Year 1 is next year, . 1 $ 5,204.40 2 $ 3,457.50 3 $ 3,457.50 4 $ 3,457.50 5 $ 3,457.50 6 and beyond $ 3,457.50 Pre-tax Cost of Debt = 10.56%

$456.40

! If you do not have a cost of debt, use the attached ratings estimator

From the current financial statements, enter the following Reported Operating Income (EBIT) = $18,599.40 ! This is the EBIT reported in the current income statement Reported Interest Expenses = $4,947.70 Output Number of years embedded in yr 6 estimate = 0 ! I use the average lease expense over the first five years to estimate the number of years of expenses in yr 6 Converting Operating Leases into debt Year Commitment Present Value 1 $ 5,204.40 $4,707.31 2 $ 3,457.50 $2,828.56 3 $ 3,457.50 $2,558.40 4 $ 3,457.50 $2,314.04 5 $ 3,457.50 $2,093.01 6 and beyond $ 3,457.50 $1,893.10 ! Commitment beyond year 6 converted into an annuity for ten years Debt Value of leases = $ 16,394.42 Restated Financials Operating Income with Operating leases reclassified as debt = Interest expenses with Operating leases classified as debt =

$ 20,330.65 $ 6,678.95

nverter

pense on this debt.

ed ratings estimator

current income statement

over the first five years f expenses in yr 6

nnuity for ten years

Inputs for synthetic rating estimation

Enter the type of firm = 1 (Enter 1 if large manufacturing firm, 2 if smaller or riskier firm, 3 if financial service firm) Enter current Earnings before interest and taxes (EBIT) = $19,055.80 (Add back only long term interest expense fo Enter current interest expenses = $5,404.10 (Use only long term interest expense for fina Enter current long term government bond rate = 8.56% Output Interest coverage ratio = 3.53 Estimated Bond Rating = AEstimated Default Spread = 2.00% Estimated Cost of Debt = 10.56% For large or stable firms If interest coverage ratio is > to -10000000 0.199999 0.2 0.649999 0.65 0.799999 0.8 1.249999 1.25 1.499999 1.5 1.749999 1.75 1.999999 2 2.499999 2.5 2.999999 3 4.249999 4.25 5.499999 5.5 6.499999 6.5 8.499999 8.50 10000000 For smaller and riskier firms If interest coverage ratio is greater than to -100000 0.499999 0.5 0.799999 0.8 1.249999 1.25 1.499999 1.5 1.999999 2 2.499999 2.5 2.999999 3 3.499999 3.5 4.499999 4.5 5.999999 6 7.499999 7.5 9.499999 9.5 12.499999 12.5 100000 For financial service firms If long term interest coverage ratio is greater than to -100000 0.049999 0.05 0.099999 0.1 0.199999 0.2 0.299999 0.3 0.399999 0.4 0.499999 0.5 0.599999 0.6 0.799999 0.8 0.999999 1 1.49999 1.5 1.99999 2 2.49999 2.5 2.99999 3 100000

Rating is D C CC CCC BB B+ BB BBB AA A+ AA AAA

Spread is 14.00% 12.70% 11.50% 10.00% 8.00% 6.50% 4.75% 3.50% 2.25% 2.00% 1.80% 1.50% 1.00% 0.75%

Rating is D C CC CCC BB B+ BB BBB AA A+ AA AAA

Spread is 14.00% 12.70% 11.50% 10.00% 8.00% 6.50% 4.75% 3.50% 2.25% 2.00% 1.80% 1.50% 1.00% 0.75%

or riskier firm, 3 if financial service firm) Add back only long term interest expense for financial firms) Use only long term interest expense for financial firms)

est coverage ratio is Rating is D C CC CCC BB B+ BB BBB AA A+ AA AAA

Spread Operating is Income Decline 14.00% -50.00% 12.70% -40.00% 11.50% -40.00% 10.00% -40.00% 8.00% -25.00% 6.50% -20.00% 4.75% -20.00% 3.50% -20.00% 2.25% -20.00% 2.00% -17.50% 1.80% -15.00% 1.50% -10.00% 1.00% -5.00% 0.75% 0.00%

CAPITAL STRUCTURE

17

Bharti Airtel
Capital Structure Current MV of Equity = Market Value of interest-bearing debt = # of Shares Outstanding = Debt Value of Operating leases (if any) Risk Premium = $116,812 $65,188 379.753 $16,394 2.80% Financial Market Current Beta for Stock = 1.23 Current Bond Rating = ASummary of Inputs Long Term Government Bond8.56% Rate = Pre-tax cost of debt = 9.56% Income Statement Current EBITDA = Current Depreciation = Current Tax Rate = Current Capital Spending= Current Interest Expense = $27,157 $6,827 54.01% $13,896 $6,679

RESULTS FROM ANALYSIS Current Optimal D/(D+E) Ratio = 41.12% 40.00% Beta for the Stock = Cost of Equity = AT Interest Rate on Debt = 1.23 12.00% 4.86% 1.22 11.97% 5.55% 9.40% $191,360 $153,076 $289.07 $188.26

Change -1.12% -0.01 -0.04% 0.69% 0.33% ($7,035) ($45,319) ($18.53) ($119.34) Ratings comparison at current debt ratio Current Interest coverage ratio = 3.04 Rating based upon coverage = AInterest rate based upon coverage = 10.56% Current rating for company = ACurrent interest rate on debt = 9.56%

Implied Growth Rate Calculation Value of Firm = $198,395 Current WACC = 9.06% Current FCFF = $2,281.27 ! I am ignoring working capital Implied Growth Rate = 7.83% If this number is >Riskfree rate, I use the riskfree rate as a perpetual growth rate.

Assumes constant saving Assumes perpeutal growth

WACC 9.06% Implied Growth Rate = 7.83% Firm Value (no growth) = $198,395 Firm Value (Perpetual Growth) $198,395 = Value/share (No Growth) = $307.60 Value/share (Perpetual Growth) $307.60 =

We use the following default spreads in our analysis. Change them in the input sheet if necessary: Rating Coverage gt and lt Spread AAA 8.5 10000000 0.75% AA 6.5 8.499999 1.00% A+ 5.5 6.499999 1.50% A 4.25 5.499999 1.80% A3 4.249999 2.00% BBB 2.5 2.999999 2.25% BB 2 2.499999 3.50% B+ 1.75 1.999999 4.75% B 1.5 1.749999 6.50% B1.25 1.499999 8.00% CCC 0.8 1.249999 10.00% CC 0.65 0.799999 11.50% C 0.2 0.649999 12.70% D -10000000 0.199999 14.00%

CAPITAL STRUCTURE
Current beta= Current Debt= Tax rate= 1.23 $81,583 54.01% Current Equity= Current EBITDA= Current Rating= $116,812 $27,157 ACurrent Depreciation= Current Interest rate (Company)= Current T.Bond rate= $6,827 9.56% 8.56%

18

D/(D+E) D/E $ Debt Beta Cost of Equity EBITDA Depreciation EBIT Interest Taxable Income Tax Net Income (+)Deprec'n Funds from Op. Pre-tax Int. cov Funds/Debt Likely Rating Pre-tax cost of debt Eff. Tax Rate D/(D+E) D/E $ Debt Cost of equity Cost of debt Cost of Capital

0.00% 0.00% $0 0.93 11.17% $27,157 $6,827 $20,331 $0 $20,331 $10,981 $9,350 $6,827 $16,177 AAA 9.31% 54.01% 0.00% 0.00% $0 11.17% 4.28% 11.17%

10.00% 11.11% $19,839 0.98 11.30% $27,157 $6,827 $20,331 $1,847 $18,484 $9,983 $8,501 $6,827 $15,327 11.01 0.77 AAA 9.31% 54.01% 10.00% 11.11% $19,839 11.30% 4.28% 10.60% $169,693 $80,119

WORKSHEET FOR ESTIMATING RATINGS/INTEREST RATES 20.00% 30.00% 40.00% 50.00% 60.00% 25.00% 42.86% 66.67% 100.00% 150.00% $39,679 $59,518 $79,358 $99,197 $119,037 1.04 1.11 1.22 1.36 1.63 11.47% 11.68% 11.97% 12.37% 13.13% $27,157 $6,827 $20,331 $4,111 $16,220 $8,760 $7,460 $6,827 $14,286 4.95 0.36 A 10.36% 54.01% 20.00% 25.00% $39,679 11.47% 4.76% 10.13% $177,603 $99,739 $27,157 $6,827 $20,331 $6,285 $14,046 $7,586 $6,460 $6,827 $13,286 $27,157 $6,827 $20,331 $9,571 $10,760 $5,812 $4,949 $6,827 $11,775 $27,157 $6,827 $20,331 $18,411 $1,920 $1,037 $883 $6,827 $7,710 $27,157 $6,827 $20,331 $22,093 ($1,763) ($952) ($811) $6,827 $6,016 0.92 0.05 CCC 18.56% 49.70% 60.00% 150.00% $119,037 13.13% 9.34% 10.85% $165,682 $72,019

70.00% 233.33% $138,876 2.25 14.85% $27,157 $6,827 $20,331 $27,859 ($7,528) ($4,066) ($3,462) $6,827 $3,365 0.73 0.02 CC 20.06% 39.42% 70.00% 233.33% $138,876 14.85% 12.15% 12.96% $138,737 $36,098

80.00% 400.00% $158,716 3.44 18.20% $27,157 $6,827 $20,331 $33,743 ($13,412) ($7,244) ($6,168) $6,827 $658 0.60 0.00 C 21.26% 32.54% 80.00% 400.00% $158,716 18.20% 14.34% 15.11% $118,995 $20,866

90.00% 900.00% $178,555 6.89 27.84% $27,157 $6,827 $20,331 $37,961 ($17,630) ($9,522) ($8,108) $6,827 ($1,281) 0.54 -0.01 C 21.26% 28.93% 90.00% 900.00% $178,555 27.84% 15.11% 16.38% $109,771 $15,466

3.23 2.12 1.10 0.22 0.15 0.08 ABB CCC 10.56% 12.06% 18.56% 54.01% 54.01% 54.01% COST OF CAPITAL CALCULATIONS 30.00% 40.00% 50.00% 42.86% 66.67% 100.00% $59,518 $79,358 $99,197 11.68% 11.97% 12.37% 4.86% 5.55% 8.54% 9.63% 9.40% 10.45% $186,688 $131,147 $191,360 $153,076 $172,087 $85,490

Value (no growth) $161,052 Value (perpetual growth) $63,844

CAPITAL STRUCTURE

19

Interest cov Interest cov Low High -10000000 0.199999 0.2 0.649999 0.65 0.799999 0.8 1.249999 1.25 1.499999 1.5 1.749999 1.75 1.999999 2 2.499999 2.5 2.999999 3 4.249999 4.25 5.499999 5.5 6.499999 6.5 8.499999 8.5 10000000

RATING D C CC CCC BB B+ BB BBB AA A+ AA AAA

Interest rate 22.56% 21.26% 20.06% 18.56% 16.56% 15.06% 13.31% 12.06% 10.81% 10.56% 10.36% 10.06% 9.56% 9.31%

CAPITAL STRUCTURE

20

ng working capital

ee rate as a perpetual growth rate.

Chart - Cost of Equity

Cost of Equity and Beta: Debt Ratios

8.00

30.00%

7.00 25.00% 6.00 20.00% 5.00

4.00

15.00%

Beta Cost of Equity

3.00
10.00% 2.00

5.00%
1.00

0.00 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

0.00%

Page 21

Debt Ratio 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Beta 0.93 0.98 1.04 1.11 1.22 1.36 1.63 2.25 3.44 6.89

Cost of Equity Bond Rating Interest rate on debt 11.17% AAA 9.31% 11.30% AAA 9.31% 11.47% A 10.36% 11.68% A10.56% 11.97% BB 12.06% 12.37% CCC 18.56% 13.13% CCC 18.56% 14.85% CC 20.06% 18.20% C 21.26% 27.84% C 21.26%

Tax Rate Cost of Debt (after-tax) 54.01% 4.28% 54.01% 4.28% 54.01% 4.76% 54.01% 4.86% 54.01% 5.55% 54.01% 8.54% 49.70% 9.34% 39.42% 12.15% 32.54% 14.34% 28.93% 15.11%

WACC 11.17% 10.60% 10.13% 9.63% 9.40% 10.45% 10.85% 12.96% 15.11% 16.38%

Firm Value (G) $63,844 $80,119 $99,739 $131,147 $153,076 $85,490 $72,019 $36,098 $20,866 $15,466