This assignment follows from your previous WACC project. Here, you must determine what the optimum capital structure is for your firm. A sample spreadsheet is provided where you may input the data that you have already found for the WACC. The spreadsheet will use Hamadas Equation to recalculate the levered betas based on the weights that you choose.

NOTE: You cannot just assume that your weights and your bond values are the same as the sample. You must choose the appropriate weights first based on the market value weights your firm currently has. Then, you must choose appropriate bond rates as you increase or decrease the weight for debt.

You must explain and reference how you chose your numbers and attach a copy of the spreadsheet.

Note that the spreadsheet has all the calculations for the WACC on the top portion, but Hamadas Equation only uses the CAPM to refigure the levered beta and the new WACC for that beta.

Tool Kit for Capital Structure Decisions Optimum Capital Structure Problem (Millions of Dollars Except Per Share Data) NUMBERS IN RED MUST BE INPUTTED, NUMBERS IN BLUE ARE CALCULATED Input Data (Millions Except Per Share Data) Tax rate Debt (D) Number of shares (n) Stock price per share (P) Data From: 39% $2,119,560,000.00 728,100,000 $12.81 Capital Structure (Millions Except Per Share Data) Market value of equity (S = P n) Total value (V = D + S) Percent financed with debt (wd = D/V) $9,326,961,000.00 $11,446,521,000.00 18.5% Percent financed with stock (ws = S/V) 81.5% Cost of Capital Cost of debt (rd) Beta (b) Risk-free rate (rRF) 3.26% 1.14 Market risk premium (RPM) 6.54% Data From 2.87% Cost of equity (rs = rRF + b RPM ) 10.31% Cost of Equity from Dividend Growth Model Future Dividend Growth Rate Last Dividend $ Share Price $ (4/5/13) 10.60% 0.0345 12.81 $ Cost of Equity from Dividend Growth Model 10.90% Cost of Equity from Bond Plus Markup Cost of debt Risk Markup Cost of Equity from Bond Plus Markup 3.26% 7.20% 10.46% 10.6% Average rs WACC 8.97% ESTIMATING THE OPTIMAL CAPITAL STRUCTURE The optimal capital structure is the one that maximizes the value of the company. Also, that same capital structure minimizes the WACC. We begin by estimating how capital structure affects the costs of debt and equity. The effects on debt are usually estimated by talking with bankers and investment bankers. Discussions with its bankers indicate that Strasburg can borrow different amounts, but the more it borrows, the higher the cost of its debt. Note: the percentages are based on market values. Estimating Optimal Capital Structure (Millions of Dollars) Percent of Firm Financed with Debt (wd) 10% 15% 20% 25% 30% 35% 40% 1. ws 90.00% 85.00% 80.00% 75.00% 70.00% 65.00% 60.00% 2. 3. 4. rd b rs 2.80% 1.07 3.00% 1.11 3.26% 1.15 3.50% 1.20 4.00% 1.26 5.00% 1.33 5.75% 1.41 9.85% 10.11% 10.41% 10.74% 11.12% 11.56% 12.07% 5. 6. rd (1T) WACC 1.71% 9.04% 1.83% 8.87% 1.99% 8.72% 2.14% 8.59% 2.44% 8.51% 3.05% 8.58% 3.51% 8.64% Notes: 1. The percent financed with equity is: ws = 1 wd 2. The interest rate on debt, rd, is obtained from investment bankers. 3. The levered beta is estimated using Hamada's formula, and unlevered beta of b U = x and a tax rate of 39%: b = bU [1 + (1-T) (wd/ws)]. 4. The cost of equity is estimated using the CAPM formula with a risk-free rate of 2.87% and a market risk premium of 6.54%: r s = rRF + (RPM)b. 5. The after-tax cost of debt is rd (1T), where T = 39%. 6. The weighted average cost of capital is calculated as: WACC = ws rs + wd rd (1-T). THE HAMADA EQUATION Hamada developed his equation by merging the CAPM with the Modigliani-Miller model. We use the model to determine beta at different amount of financial leverage, and then use the betas associated with different debt ratios to find the cost of equity associated with those debt ratios. Here is the Hamada equation: debt ratios to find the cost of equity associated with those debt ratios. Here is the Hamada equation: b = bU x [1 + (1-T) x (D/S)] b = bU x [1 + (1-T) x (wd/ws)] bU = b / [1 + (1-T) x (wd/ws)] Here b is the leveraged beta, bU is the beta that the firm would have if it used no debt, T is the marginal tax rate, D is the market value of the debt, and S is the market value of the equity. Levered beta, b Current wd 1.14 19% Current ws 81% 39% Tax rate bU 1.0012 As shown above, beta rises with financial leverage. With beta specified, we can determine the effects of leverage on the cost of equity