Reference no: EM13979512

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 bossremembers something from his MBA programme about capital structure being irrelevant, but isn't quite surewhat that means. You do remember that capital structure is irrelevant under the Modigliani-Miller (M&M)assumptions and will demonstrate this point for your boss by showing that the weighted average cost of capitalremains constant across different levels of debt. So assume that the M&M assumptions hold as you prepareresponses for your boss.You would like to analyze relatively modest changes to Home Depot's capital structure. You would like toconsider two scenarios: the firm issues $1 billion in new debt to repurchase stock, and the firm issues $1 billionin new stock to repurchase debt. Assume the cost of unlevered equity (ra) is 12%.

1. Obtain the financial information you need for Home Depot.a. Go to Nasdaq.com, enter Home Depot's stock symbol (HD) and go to "Summary Quotes" onthe left-hand side. Get the current stock price and number of shares outstanding.

b. Click on "Financials" and the annual income statement should appear. Select the balance sheet.Put the cursor in the middle of the sheet, right-click your mouse, and select "Export to MicrosoftExcel."

c. To get the cost of debt for Home Depot, go to NASD BondInfo(https://cxa.marketwatch.com/finra/BondCenter/Default.aspx). Select Bond Type: Corporate andsearch by symbol (HD). The next page will contain information for all of Home Depotoutstanding bonds.

Select the yield on the 4.4% coupon bond (HD.GN). For simplicity,additionally assume that Home Depot's debt is risk-free so that the cost of debt is equal to thedebt's yield to maturity.

2. Compute the D/E ratio for Home Depot. Approximate the market value of debt by the book value of netdebt; include both Long-Term Debt and short-Term debt/Current Portion of Long-Term Debt from thebalance sheet. Use the stock price and number of outstanding shares to calculate the market value ofequity.

3. Compute the cost of levered equity for Home Depot using their current debt-to-equity ratio.

4. Compute the current weighted average cost of capital.

5. Repeat steps 3 and 4 for the two scenarios you would like to analyse, issuing $1 billion in debt torepurchase stock, and issuing $1 billion in stock to repurchase debt. (Although you realize that the costof debt capital may change with changes in leverage, for these modestly small changes you decide toassume that rd remains constant.) What is the market D/E ratio in each of these cases?

6. Prepare a written explanation for your boss explaining the relationship between capital structure and thecost of capital in this exercise.

7. What implicit assumptions in this exercise generate the results in question 5? How might your resultsdiffer in the "real world"