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Live Case Study #2 – Estimating Cost of Debt and the WACC

FIN:3300 – Corporate Finance

2022

Instructions:

Answer each of the questions listed below for the company you selected in the first live case study.  Use the most current information available.  

Cite all sources of information used for your analysis. If you use the annual report (i.e., SEC form 10-K), note the page number where you find the information.  

Credit ratings: (Source Bloomberg)

Default Spread Table:

Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ratings.htm

1. Estimate the Cost of Debt

What is the cost of debt for your company?

Use the default spread (default premium) table in this case study and identify the default spread for the debt rating given for your company. Add the default spread to your risk-free rate (which you have identified for Live Case Study #1) to estimate the cost of debt. (See Chapter 9 lecture slides, slide # 25) 

 Cost of Debt = Risk free rate + default spread

2. Estimate the Tax Rate

What is the firm’s tax rate? Explain how you get the number.

You may find the effective tax rate for your company from the SEC Form 10-K filings:

https://www.sec.gov/edgar/searchedgar/companysearch.html

· In the search box, type the ticker of your company, and click when you see your company in the list.

· Under “Selected Filings”, choose 10-k

· Locate and click on the most recent 10-k annual filing

· In the 10-k search for “effective tax rate” (CTRL+F). Locate the section where effective tax rates are reported and calculate the average for the last three years.

· If the effective tax rates are not readily available in the 10-k, do the following:

o In the “Sections” menu, choose “Financial Statements”

o Choose “Consolidated Statements of Operations” (or “of income”)

o Compute the tax rate as the ratio of “provision for income taxes” over “income before income taxes” for the last three years and calculate the average

3. Estimate the Market Value of Common Equity and Debt

a. Identify the current number of outstanding shares. (You may get this from Yahoo Finance, not from 10-K)

b. What is the current stock price? (You may get this from Yahoo Finance)

c. Estimate the market value of common equity. (stock price * number of outstanding shares)

d. What is the market value of total debt outstanding? Explain how you get the number.

You can assume that the book value of debt listed on the consolidated balance sheet (on 10-k) is a close proxy for the market value of debt. (Use “long term debt” + “short term portion of long term debt” + “commercial paper” (if any) from most recent consolidated balance sheet in 10-k filing)

Note the following

· For AAPL, these debt items are marked as “Term Debt”.

· For AMZN include “Long-term lease liabilities”.

· For MSFT do not include the 2018 effective tax rate in your calculations since it is an outlier.

· For MSFT, include “Operating lease liabilities”.

· For WMT, include finance and operating lease obligations

4. Estimate the WACC

Using the information identified in the above questions and in Live Case Study #1, estimate the firm’s WACC. Show your work. Note that D comes from question 3-d and E comes from question 3-c.

5. Estimate the WACC under a target debt ratio

Suppose the company increases

· its debt-to-value ratio (D/D+E) by 30 percentage points (for example if your original debt-to-value ratio is 5%, then the new debt-to-value ratio will be 5%+30%=35%),

· its debt rating decreases by one category (one category that will lead to a higher default spread in the default spread table, e.g. from AA to AA-)  

Its tax rate does not change. What will be the new cost of debt, cost of equity and the WACC? Show your work. 

The formula below may be useful to calculate the new cost of equity:

Hint: Note that you need to

· first calculate r_a (return of assets) using the current levels of r_e, r_d and D/E before the changes using the formula given below.

· Then use the cost of equity formula above with the new levels of r_d and D/E, to get the new r_e.

· Then calculate the new WACC using the new cost of debt, new cost of equity, and the new D/(D+E).

Here are a couple of other useful formulas: