capstru'xls Optimizing Capital Structure

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capstru.xlsOptimizing Capital Structure

• Aswath Damodaran
• A podcast

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Overview

• Suited for most non-financial service firms
• What the spreadsheet tries to do
• Estimate the cost of equity and capital at the
  firms 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)

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A picture of the model
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Before you start your inputs, set up for circular
reasoning
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Inputs Financial Statement numbers
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Input market-based data
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Capitalizing Leases, if any
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Market Inputs
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The Output
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The implied growth rate!
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Problem Checker1. 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.

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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 firms
  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.

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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 firms 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.