Prior to beginning work on this assignment, review the Chapter 14 data case in your course textbook. Next, complete all of the requirements of the data case.
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 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 average cost of capital remains constant under various debt levels. 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: a) the firm issues $1 billion in new debt to repurchase stock, and b) the firm issues $1 billion in new stock to repurchase debt. Use Excel to answer the following questions using Eqs. 14.5 and 14.6 from your course textbook, assuming a cost of unlevered equity (rU) of 12%.
In your assignment, address the following:
•Step 1: Obtain the financial information for Home Depot.
•Step 2: Compute the market debt-to-equity (D/E) ratio for Home Depot. Approximate the market value of debt by using the book value of net debt; include both long- and short-term debt, as well as 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.
•Step 3: Compute the cost of levered equity (rE) for Home Depot using their current market debt-to-equity ratio and Eq. 14.5 in your course textbook.
•Step 4: Compute the current weighted average cost of capital (WACC) for Home Depot using Eq. 14.6 in your course textbook given their current debt-to-equity ratio.
•Repeat Steps 3 and 4 for the two scenarios you would like to analyze, issuing $1 billion in debt to repurchase stock, and issuing $1 billion in stock to repurchase debt. (Although you realize that the cost of debt 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?
•Prepare a written explanation for your boss explaining the relationship between capital structure and the cost of capital in this exercise.
o Identify the relative cost of each component of the capital structure.
o Explain the impact of taxes on the cost of capital.
o Justify the decision to use $1 billion in debt to repurchase stock.
•Determine the implicit assumptions in this exercise generated by the results found above.
•Explain how your results might differ in the real world.
The Chapter 14 Data Case paper:
•Must be three double-spaced pages in length (not including title and references pages)
•Must include a separate title page with the following:
o Title of paper
o Student’s name
o Course name and number
o Instructor’s name
o Date submitted
•Must use at least FOUR scholarly and/or industry sources.
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