You are working for Home Depot and have been asked to help explore the impact of a potential debt issue. The CFO and other top managers in the finance division are all aware that increasing the debt load will have ramifications in the credit markets. Specifically, they realize that the firm’s debt rating could change, which will raise the cost of borrowing as well as possibly lower the value of the existing debt. No one is exactly sure what the impact will be, but they all agree that it deserves investigation. You have been summoned to an executive-level meeting and asked to estimate the impact of increasing the debt of the firm. You are to consider four different scenarios: issuing $1 billion, $10 billion, $20 billion, and $30 billion in new debt. In each case, proceeds from the debt will be used to repurchase stock (so the total amount of financing for the firm will not change–just the balance between debt and equity). The CFO believes that the $1 billion level will not affect the firm’s credit rating. However, each larger increase in debt will cause the debt to be downgraded one letter grade (e.g., from Baa to Ba). For example, the $10 billion scenario will lower the current debt rating one level, the $20 billion scenario would lower the rating still another level, and so on. Your job is to determine the impact of additional debt on borrowing costs at each debt level. Assume the new debt will be raised by issuing 10-year bonds.
1. Determine the current debt rating for The Home Depot.
• Research the current bond rating at FINRA (finra markets.morningstar.com/ BondCenter/). Select the “Corporate” toggle, enter the symbol for Home Depot (HD), and click “Show Results.”
• What is the Moody’s bond rating on the Home Depot bond with the maturity closest to 10 years from today? What is the yield on this bond?
2. Because lower bond ratings will lead to higher interest costs, you will need to determine those costs. Go to Aswath Damodaran’s Web page reporting bond spreads by credit rating (http://pages.stern.nyu.edu/~adamodar/). You will see a table of bond spreads. These spreads represent the increased yield a bond must pay over the U.S. Treasury of the same maturity. Choose the 10-year spread for Home Depot’s current rating and the three ratings below it. The spreads are in basis points; a basis point is 1/100th of a percentage point (thus, 50 basis points is 0.5%). We will adjust these old spreads to estimate the current spread.
• Because these spreads are dated and averaged across all maturities, you will need to create new yield spreads for the various ratings. Use the current difference between the Home Depot bond’s yield and the 10-year Treasury as the true spread for the rating. Using Excel, compute the spreads for the other ratings, by adding the difference in spreads from the table to the new true spread for Home Depot’s rating. Finally, determine the yield for each rating by adding the new spread to the yield on the 10-year Treasury bond.
• Compute the required yields on 10-year bonds at each of the new debt levels requested.
3. What factors cause the bond rating to fall, and the bond yields to increase, as Home Depot increases its debt levels?