Data Case for Chapter 14: Capital Structure in a Perfect Market
You work in the corporate finance division of The Home Depot and your boss has asked you to review the firm’s capital structure. Specifically, your boss is considering changing the firm’s debt level. Your boss remembers something from his MBA program about capital structure being irrelevant, but isn’t 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 average 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 Depot’s capital structure. You would like to consider two scenarios: the firm issues $1 billion in new debt to repurchase stock, and the firm issues $1 billion in new stock to repurchase debt. Use Excel to answer the following questions using Eq. 14.5 and Eq. 14.6, and assuming a cost of unlevered equity (rU) of 12%.
Your boss was impressed with your presentation regarding the irrelevance of capital structure from Chapter 14 but, as expected, has realized that market imperfections like taxes must be accounted for. You have now been asked to include taxes in your analysis. Your boss knows that interest is deductible and has decided that the stock price of Home Depot should increase if the firm increases its use of debt. Thus, your boss wants to propose a share repurchase program using the proceeds from a new debt issue and wants to present this plan to the CEO and perhaps to the Board of Directors.
Your boss would like you to examine the impact of two different scenarios, adding a modest level of debt and adding a higher level of debt. In particular, your boss would like to consider issuing $1 billion in new debt or $5 billion in new debt. In either case, Home Depot would use the proceeds to repurchase stock.