PRELIMINARYSTUFFANDINPUTS

Objective
Beforeyoustart
Inputs
Units
Incomeinputs

BalanceSheet
MarketData

TaxRate
DefaultSpreads

READINGTHEOUTPUT
Summary

Details
References
CorporateFinance:TheoryandPractice,Chapter18
AppliedCorporateFinance:Chapter8

PRELIMINARYSTUFFANDINPUTS
Thisspreadsheetallowsyoutocomputetheoptimalcapitalstructureforafinancial
servicefirm.
Openpreferencesinexcel,gointocalculationoptionsandputacheckintheiterationbox.
Ifitisalreadychecked,leaveitasis.
Theinputsareprimarilyintheinputsheet.Ifyourcompanyhasoperatingleases,
usetheoperatingleaseworksheettoenteryourleaseorrentalcommitments.
Enterallnumbersinthesameunits(000s,millionsorevenbillions)
Thekeyincomeinputistheearningsbeforelongterminterestexpensesanddepreciation.
Enterthemostupdatednumbersyouhaveforeach(eveniftheyare12monthtrailing
numbers).Ifthemostrecentperiodforwhichyouhavedatahasanoperatingincomethat
isabnormal,eitherbecauseofextraordinarylosses/gainsorsomeotheroccurrence,use
anaverageoperatingincomeoverthelastfewyears.
Earningsbeforelongterminterestexp&depr=NetIncome+taxespaid+longterm
interestexpenses
Iflongterminterestexpensesarenotbrokenout,apportionthetotalinterestexpenses
baseduponhowmuchlongtermdebtthefirmhas,relativetototalinterestbearingdebt.
Fromthestatementofcashflows,alsoenterthecapitalspendingfromtherecentperiod.
P.S:Forfinancialservicefirms,bothdepreciationandcapitalspendingarelikelytobe
smallnumbers.
Enterthebookvalueoflongtermdebt.Ifyouhaveamarketvalueenterthat
number.Alternatively,inputtheaveragematurityofthedebtandIwillestimatethe
marketvalueofdebt.
Enterthecurrentstockprice,thecurrentlongtermgovernmentbondrate,therisk
premiumyouwouldliketousetoestimateyourcostofequityandthecurrentratingfor
yourfirm.Ifyoudonothavearating,thereisanoptionforyouattheverybottomof
thespreadsheettocomputeasyntheticrating.
Enteramarginaltaxrate,ifyoucanestimateit.Otherwise,usetheeffectivetaxrate.
Thisspreadsheethasinterestcoverageratios,ratingsanddefaultspreadsbuiltintoitin
theworksheet.Youcanchoosebetweentwotables,oneforlargeandstable
firms,andtheotherforsmallorriskyfirms.Ifyouwantyoucanchangetheinterest
coverageratiosandratingsinthesetables.
READINGTHEOUTPUT
Thesummaryprovidesapictureofyourfirm'scurrentcostofcapitalanddebtratio,and
comparesittoyourfirm'soptimaldebtratioandthecostofcapitalatthatlevel.The
firmvalueiscomputedateachdebtratio,baseduponhowtheexpectedoperatingincome
andthecostofcapital.Theoptimaldebtratioisthatratioatwhichfirmvalueis
maximized.Itmightnotbethesamepointatwhichcostofcapitalisminimized.
Thedetailsofthecalculationateachdebtratioarebelowthesummary.

actice,Chapter18

Question
Q1:WhatdoIdoexcelsaystherearecircularreferences?
Q2:Myspreadsheethasgonecrazy.Igeterrorsallover.
WhatdidIdowrong?
Q3:Iamenteringtheinputsformycompanybutthe
optimalnumbersdonotseemtochangefromthe
originals
Q4:Iamgettinganoptimaldebtratioof0%.Thiscan't
beright.Canit?
Q5:Mycostofcapitalatmyoptimaldebtratioishigher
thanthecurrentcostofcapital.Ithoughtitwassupposed
tobelower.

Answer
Gointopreferences,choosecalculationoptionsandmakesuretheiterationboxhasacheckinit.
Iamsorrytosaythis,butyouprobablyjustmadeaninputerror.Whileyoumighthave
fixedit,theiterationsinthespreadsheetmakeitverysensitiveandtheerrorswillnot
goaway.Theonlyfix(Sorry,sorry)istocopytheinputsintoafreshversionofthespreadsheet.
Youprobablyforgottochecktheiterationbox(seeQ1)
Sure.Ifyouroperatingincomeiseithernegativeorverylow,relativetoyourfirmvalue,
youcanendupatanoptimaldebtratioof0%.Forinstance,ifyouhaveEBITof100ona
firmvalueof10000,a10%debtratiowouldprobablypushyouintoaCratingandgive
youaveryhighcostofcapital.
Generally,youareright.However,Iwouldsuggestthatyoulookatthreefactors:
Ifyouroptimalisjustslightlyhigherorlowerthanyourcurrentdebtratio,itispossiblethatyou
areclosertotheoptimalthanthestatedoptimal.Letmeexplain.Assumethatyouareata24%debtratio
andtheoptimalcomesoutto30%.Thetrueoptimalisreallysomewherearound30%since
Iamconstrainedtoworkin10%incrementsofthedebtratio.Ifthetrueoptimalwere
26%,yourcurrentdebtratioof24%isclosertotheoptimal.
RatingDifferences:Oneofthecostsofratingacompanybasedonlyontheinterest
coverageratioisthattheratingmightbeverydifferentfromtheactualrating.Thus,your
currentcostofcapitalisbaseduponyourcurrentrating,andtheoptimalisbasedupon
thesyntheticratings,andthetwodon'tmatch,thecurrentandtheoptimalcostofcapital
canbemismatched.Youcangetaroundthisbyswitchingtoasyntheticratingforcomputing
thecurrentcostofcapital(intheinputsheet).
Existingdebtatlowrates:Iassumeinthespreadsheetthatexistingdebtgetsrefinancedat
thenewpretaxcostofdebtateachdebtratio.Consequently,ifyouhavealotofolddebton
yourbooksatmuchlowerrates,theinterestexpensethatIreportwillbemuchhigherthan
youractualinterestexpense.This,inturn,canaffectyourinterestcoverageratioandrating.
This,too,youcanfixbylockingindebtatcurrentratesintheinputsheet.

Inputs
Pleaseenterthenameofthecompanyyouareanalyzing:

Summit

FinancialInformation
Earningsbeforelongterminterestexpenses,depreciation&amortization

$1,203.84

DepreciationandAmortization:

$0.00

CapitalSpending:

$0.00

Interestexpenseonlongtermdebt:

$528.84

Taxrateonordinaryincome:

35.00%

CurrentRatingonlongtermdebt(ifavailable):
Interestratebaseduponrating:

A+
6.80%

MarketInformation
Numberofsharesoutstanding:

173.768

Marketpricepershare:

$26.43

Betaofthestock:
Bookvalueoflongtermdebt:
Canyouestimatethemarketvalueofthelongtermdebt?

1.10
$3,573.00
No

Ifso,enterthemarketvalueofdebt:
Doyouwantmetotryandestimatemarketvalueofdebt?

Yes

Ifyes,entertheaveragematurityofoutstandingdebt?

3.00

Doyouhaveanyoperatingleases?

No

GeneralMarketData
Currentlongterm(LT)governmentbondrate:

6.00%

Riskpremium(foruseintheCAPM)

6.31%

GeneralData
Whichspread/ratiotablewouldyouliketouseforyouranlaysis?

Doyouwanttoassumethatexistingdebtisrefinancedatthe'new'rate?

Yes

Doyouwantthefirm'scurrentratingtobeadjustedtothesyntheticrating?

Yes

(inpercent)
(inpercent)

(YesorNo)
(YesorNo)

Inputsforsyntheticratingestimation
Enterthetypeoffirm=
Earningsbeforeinterestandtaxes(EBIT)=
Currentinterestexpenses=
Currentlongtermgovernmentbondrate=
Output
Interestcoverageratio=
EstimatedBondRating=
EstimatedDefaultSpread=
EstimatedCostofDebt=
Forlargefinancialservicefirms
Ifinterestcoverageratiois
>
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
0.749999
0.75
0.899999
0.9
1.199999
1.2
1.49999
1.5
1.99999
2
2.49999
2.5
2.99999
3
100000

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

Forsmallerandriskierfinancialservicefirms
Ifinterestcoverageratiois
greaterthan
to
Ratingis
100000
0.049999
D
0.05
0.099999
C
0.1
0.199999
CC
0.2
0.299999
CCC
0.3
0.399999
B
0.4
0.549999
B
0.55
0.699999
B+
0.7
0.999999
BB
1
1.199999
BB+
1
1.499999
BBB
1.5
1.999999
A
2
2.499999
A
2.5
2.999999
A+
3
3.499999
AA
3.5
100000
AAA

1 (Enter1iflargefinancialservicefirm,2ifsmallerfinancialservicefirm)
$1,203.84 (Addbackonlylongterminterest
$528.84 (Useonlylongterminterestexpen
6.00%
2.28
A+
1.40%
7.40%

Spreadis
20.00%
12.00%
10.00%
7.50%
6.50%
5.65%
4.50%
3.65%
3.20%
2.50%
1.70%
1.50%
1.40%
1.25%
0.75%

DropinEBITDA
50.00%
40.00%
40.00%
40.00%
25.00%
20.00%
20.00%
20.00%
20.00%
20.00%
17.50%
15.00%
10.00%
5.00%
0.00%

Spreadis
20.00%
12.00%
10.00%
7.50%
6.50%
5.65%
4.50%
3.65%
3.20%
2.50%
1.70%
1.50%
1.40%
1.25%
0.75%

DropinEBITDA
50.00%
40.00%
40.00%
40.00%
25.00%
20.00%
20.00%
20.00%
20.00%
20.00%
17.50%
15.00%
10.00%
5.00%
0.00%

cialservicefirm)
ddbackonlylongterminterestexpenseforfinancialfirms)
eonlylongterminterestexpenseforfinancialfirms)

CAPITALSTRUCTURE

17

Summit
CapitalStructure
CurrentMVofEquity=
MarketValueofinterestbearingd
#ofSharesOutstanding=
DebtValueofOperatingleases(if
RiskPremium=

$4,593
$4,326
173.768
$0
6.31%

FinancialMarket
CurrentBetaforStock=
CurrentBondRating=
SummaryofInputs
LongTermGovernmentBond
Pretaxcostofdebt=

D/(D+E)Ratio=

Assumesperpeutalgrowth

1.10
A+
6.00%
6.80%

RESULTSFROMANALYSIS
Current
Optimal
48.50%
70.00%

IncomeStatement
CurrentEBITDA=
CurrentDepreciation=
CurrentTaxRate=
CurrentCapitalSpending=
CurrentInterestExpense=

Change
21.50%

BetafortheStock=
CostofEquity=

1.1
12.94%

1.72
16.84%

0.62
3.89%

ATInterestRateonDebt=

4.81%

4.39%

0.42%

WACC
ImpliedGrowthRate=
FirmValue(PerpetualGrowth
Value/share(PerpetualGrowth

9.00%
0.21%
$8,919
$26.43

8.12%

0.88%

$11,006
$38.44

$2,087
$12.01

Weusethefollowingdefaultspreadsinouranalysis.Changethemintheinputsheetifnecessary:
Rating
Coveragegt
andlt
Spread
DropinEBIT
AAA
3
100000
0.75%
0.00%
AA
2.5
2.99999
1.25%
5.00%
A+
2
2.49999
1.40%
10.00%
A
1.5
1.99999
1.50%
15.00%
A
1.2
1.49999
1.70%
17.50%
BBB
0.9
1.199999
2.50%
20.00%
BB
0.6
0.749999
3.65%
20.00%
B+
0.5
0.599999
4.50%
20.00%
B
0.4
0.499999
5.65%
20.00%
B
0.3
0.399999
6.50%
25.00%
CCC
0.2
0.299999
7.50%
40.00%
CC
0.1
0.199999
10.00%
40.00%
C
0.05
0.099999
12.00%
40.00%
D
100000
0.049999
20.00%
50.00%

$1,204
$0
35.00%
$0
$529

ImpliedGrowthRateCalculation
ValueofFirm
$8,919
CurrentWACC
9.00%
CurrentFCFF
$782.50 !Iamignoringworkingcapital
ImpliedGrowt
0.21%
Ifthisnumberis>yourriskfreerate,Iusetheriskfreerateasaperpetualgrow

Ratingscomparisonatcurrentdebtratio
CurrentInterestcoverageratio=
2.28
Ratingbaseduponcoverage=
A+
Interestratebaseduponcoverage=
7.40%
Currentratingforcompany=
A+
Currentinterestrateondebt=
6.80%
Dropinoperatingincomebasedoncurrentra 10.00%

CAPITALSTRUCTURE
Currentbeta=
CurrentDebt=
Taxrate=

1.10
$4,326
35.00%

D/(D+E)
D/E
$Debt
Beta
CostofEquity
%DropinEBITD
EBITDA
Depreciation
EBIT
Interest
TaxableIncome
Tax
NetIncome
(+)Deprec'n
FundsfromOp.

0.00%
0.00%
$0
0.68
10.31%
0.00%
$1,338
$0
$1,338
$0
$1,338
$468
$869
$0
$869

10.00%
11.11%
$892
0.73
10.62%
0.00%
$1,338
$0
$1,338
$60
$1,277
$447
$830
$0
$830

PretaxInt.cov
Funds/Debt
LikelyRating
Pretaxcostofdeb
Eff.TaxRate

AAA
6.75%
35.00%

22.22
0.93
AAA
6.75%
35.00%

11.11
0.44
AAA
6.75%
35.00%

D/(D+E)
D/E
$Debt
Costofequity
Costofdebt
CostofCapital
Value(perpetualg

0.00%
0.00%
$0
10.31%
4.39%
10.31%
0
$8,627

10.00%
11.11%
$892
10.62%
4.39%
9.99%
0
$8,902

20.00%
25.00%
$1,784
11.00%
4.39%
9.68%
0
$9,195

18

$4,593
CurrentEquity=
CurrentDepreciation=
$1,204
CurrentEBITDA=
CurrentInterestrate(Company)=
A+
CurrentRating=
CurrentT.Bondrate=
$1,338
AdjustedEBITDA=
WORKSHEETFORESTIMATINGRATINGS/INTERESTRATES
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
25.00%
42.86%
66.67%
100.00%
150.00%
233.33%
$1,784
$2,676
$3,568
$4,460
$5,351
$6,243
0.79
0.87
0.98
1.13
1.35
1.72
11.00%
11.50%
12.17%
13.10%
14.50%
16.84%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
$1,338
$1,338
$1,338
$1,338
$1,338
$1,338
$0
$0
$0
$0
$0
$0
$1,338
$1,338
$1,338
$1,338
$1,338
$1,338
$120
$181
$241
$301
$361
$421
$1,217
$1,157
$1,097
$1,037
$976
$916
$426
$405
$384
$363
$342
$321
$791
$752
$713
$674
$635
$596
$0
$0
$0
$0
$0
$0
$791
$752
$713
$674
$635
$596

Interestcov
Low

$0
6.80%
6.00%

80.00%
400.00%
$7,135
2.46
21.50%
10.00%
$1,204
$0
$1,204
$528
$676
$237
$439
$0
$439

90.00%
900.00%
$8,027
4.67
35.49%
10.00%
$1,204
$0
$1,204
$594
$610
$213
$396
$0
$396

7.41
5.55
4.44
0.28
0.20
0.15
AAA
AAA
AAA
6.75%
6.75%
6.75%
35.00%
35.00%
35.00%
COSTOFCAPITALCALCULATIONS
30.00%
40.00%
50.00%
42.86%
66.67%
100.00%
$2,676
$3,568
$4,460
11.50%
12.17%
13.10%
4.39%
4.39%
4.39%
9.37%
9.06%
8.75%
0
0
0
$9,508
$9,843
$10,202

3.70
0.12
AAA
6.75%
35.00%

3.17
0.10
AAA
6.75%
35.00%

2.28
0.06
A+
7.40%
35.00%

2.03
0.05
A+
7.40%
35.00%

60.00%
150.00%
$5,351
14.50%
4.39%
8.43%
0
$10,589

70.00%
233.33%
$6,243
16.84%
4.39%
8.12%
1
$11,006

80.00%
400.00%
$7,135
21.50%
4.81%
8.15%
0
$9,873

90.00%
900.00%
$8,027
35.49%
4.81%
7.88%
0
$10,220

Interestcov
High

Dropin
EBITDA

RATING

Interestrate

CAPITALSTRUCTURE
100000
0.05
0.1
0.2
0.3
0.4
0.5
0.6
0.75
0.9
1.2
1.5
2
2.5
3

0.049999
0.099999
0.199999
0.299999
0.399999
0.499999
0.599999
0.749999
0.899999
1.199999
1.49999
1.99999
2.49999
2.99999
100000

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

26.00%
18.00%
16.00%
13.50%
12.50%
11.65%
10.50%
9.65%
9.20%
8.50%
7.70%
7.50%
7.40%
7.25%
6.75%

19
50.00%
40.00%
40.00%
40.00%
25.00%
20.00%
20.00%
20.00%
20.00%
20.00%
17.50%
15.00%
10.00%
5.00%
0.00%

CAPITALSTRUCTURE

!Iamignoringworkingcapital

erate,Iusetheriskfreerateasaperpetualgrowthrate.

20

CAPITALSTRUCTURE

21

CAPITALSTRUCTURE

22

Chart - Cost of Equity

CostofEquityandBeta:DebtRatios
5.00

40.00%

4.50

35.00%

4.00
30.00%
3.50
25.00%

3.00
2.50

20.00%

2.00

15.00%

1.50
10.00%
1.00
5.00%

0.50
0.00

0.00%
0%

10%

20%

30%

40%

50%

60%

Page 23

70%

80%

90%

Beta
CostofEquity

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

Beta
0.68
0.73
0.79
0.87
0.98
1.13
1.35
1.72
2.46
4.67

CostofEquity
10.31%
10.62%
11.00%
11.50%
12.17%
13.10%
14.50%
16.84%
21.50%
35.49%

BondRating Interestrateondebt
AAA
6.75%
AAA
6.75%
AAA
6.75%
AAA
6.75%
AAA
6.75%
AAA
6.75%
AAA
6.75%
AAA
6.75%
A+
7.40%
A+
7.40%

TaxRate
35.00%
35.00%
35.00%
35.00%
35.00%
35.00%
35.00%
35.00%
35.00%
35.00%

CostofDebt(aftertax)
4.39%
4.39%
4.39%
4.39%
4.39%
4.39%
4.39%
4.39%
4.81%
4.81%

WACC
10.31%
9.99%
9.68%
9.37%
9.06%
8.75%
8.43%
8.12%
8.15%
7.88%

FirmValue(G)
$8,627
$8,902
$9,195
$9,508
$9,843
$10,202
$10,589
$11,006
$9,873
$10,220