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capstru.xls Optimizing Capital Structure

capstru.xls Optimizing Capital Structure. Aswath Damodaran A podcast. Overview. Suited for: most non-financial service firms What the spreadsheet tries to do: Estimate the cost of equity and capital at the firm’s current debt ratio

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capstru.xls Optimizing Capital Structure

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  1. capstru.xlsOptimizing Capital Structure Aswath Damodaran A podcast

  2. Overview • Suited for: most non-financial service firms • What the spreadsheet tries to do: • Estimate the cost of equity and capital at the firm’s current debt ratio • Estimate how both inputs would changes at alternative debt ratios (ranging from 0% to 90%) • Estimate the cost of capital at alternative debt ratios and the optimal debt ratio (based upon minimizing the cost of capital)

  3. A picture of the model…

  4. Before you start your inputs, set up for circular reasoning…

  5. Inputs: Financial Statement numbers

  6. Input market-based data

  7. Capitalizing Leases, if any…

  8. Market Inputs

  9. The Output

  10. The implied growth rate!

  11. Problem Checker:1. I am getting Div/0 and other errors all over! • Why? • The iterative process in the spreadsheet will make your spreadsheet incredibly sensitive to small input errors. Thus, entering the riskfree rate as 5..30% instead of 5.30% can set the spreadsheet spinning towards spreadsheet hell. • What to do? • If you love messing with Excel, you can try to coax the spreadsheet back from hell. • I find it quicker to open a fresh version of the spreadsheet and copy the input page (and the lease information, if any) into it.

  12. 2. My cost of capital is higher at the optimal than it is currently… • Why? • We work in 10% increments. Thus, if the true optimal debt ratio is 26%, your reported optimal will be 30%. If your actual debt ratio is 24%, you are already closer to the true optimal than the computed optimal. • Use the actual debt ratio as the optimal debt ratio. • The optimal debt ratio is computed using synthetic ratings at every debt ratio. If your current cost of capital is computed using an actual rating and it is much higher than your synthetic rating (at the same debt ratio), you can get this result. • Use the option (on page 8) to set the firm’s current rating = synthetic. • The interest expenses at each debt ratio in the table are computed on the assumption that all of the debt at that ratio is funded at the pre-tax cost of debt that is estimated for that ratio. The current interest coverage ratio reflects actual interest expenses and may yield a different rating. • Use the option (on page 8) and answer “No” to the question of whether you want your existing debt refinanced at the new rate.

  13. 3. I am getting an absurdly high (or low) optimal debt ratio! • Check to make sure that you have not mismatched units (everything on the input page should be in the same units) and that you are not carrying some other firm’s leases in your worksheet. • There are two key firm-specific factors that may drive a really high or low optimal debt ratio: • Marginal tax rate: Higher marginal tax rates will yield higher optimal debt ratios. • Cash flow generating capacity (relative to market value): Measures of cash flow (EBITDA/ Enterprise value) are highly correlated with optimal debt ratios.

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