Should Businesses Use Debt or Cash

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Should Businesses Use Debt or Cash Powered By Docstoc
					ORACLE
A case study on the effect of changing a company's capital structure.

You have the opportunity to visit Oracle, the business software company. Oracle, based in California,
offers software development and implementation in application areas such as accounting, logistics and
human-resource management to large businesses in Europe, North America and around the world. In 2004
the company had sales of over $10 billion.

In recent months the company's stock price has been depressed, and management is concerned about
re-examining the financial structure. Management is also concerned with the financing of forthcoming acquisitions:
should Oracle continue to take advantage of its strong cash flow, or should it begin to use debt financing?

You have been asked to evaluate whether the company has an
appropriate amount of debt. You have collected the following information about Oracle's current position:
Current share price:           13.15 $
Shares outstanding:           5,220 million
Beta of the stock based on the S&P500:                1.51
Debt outstanding:               171 $ million
Debt rating:            A-
Market rate on bonds with rating A-                6.26%
Government 10-year bond rate:           4.50%
S&P500 long-run expected return        10.50% or             5.00% over governments
Company's marginal tax rate:              32%
2004 estimated pretax profit (EBIT)      3966
2004 est. book value of equity           7995
Based on the company's business, its interest coverage and other factors, you have prepared a table
showing what an increase in long term debt would do to the company's ratings and its cost of borrowing
as well as several key ratios:
                                                  Interest    Debt /
 Additional        New      Interest Interest    coverage capitaliz Debt/book
       debt      Rating          rate expense         ratio    ation     equity
          0          A-       6.26%         11    371.49         0%        0.0
    10000            A-       6.26%        637       7.23       15%        1.3
    15000        BBB+         6.36%        965       5.11       22%        1.9
    20000          BBB        6.51%      1,313       4.02       29%        2.5
    25000           BB-       9.10%      2,291       2.73       37%        3.1
1. Should Oracle take on additional debt? If so, how much?
2. What is the weighted average cost of capital before and after the additional debt?
3. What will be the estimated price per share after the company takes on new debt?



ORACLE
Solution:
In order to get the company's beta at different levels of debt, we have to first calculate the unlevered beta.
Current levered beta:           1.51
Current debt/equity (D/E) ratio = debt/(share price*shares outstanding):                 0.25%
Current debt/capital (D/C) ratio = debt/(debt +share price*shares outstanding):          0.25%
The levered beta is found from: Betalev=Betaunlev(1+(1-tax rate)(D/E)
The current unlevered beta is Betaunlev=Betalev/(1+(1-tax rate)(D/E)) =                    1.51

Now we can calculate, for different debt levels, the cost of equity, the cost of debt, and the WACC:

             Value of                                                                After-tax Weighted          13.54




                                                                                                             Cost of Capital
                                                                                                                  %
              Equity        Shares       New                 Levered      Cost of     Cost of   Cost of
Total debt Remaining      (millions)    Rating Interest rate    Beta       Equity        Debt    Capital Leverage      13.08     13.10             Tax shield
                                                                                                                        % 12.87    %
      171    68,643       5,220.00          A-       6.26%      1.51      13.56%       4.26%    13.54%          0%                                         3
                                                                                                                             % 12.67
  10,171     58,643       4,459.54          A-       6.26%      1.69      14.61%       4.26%    13.08%         15%                                      204
                                                                                                                                %
  15,171     53,643       4,079.32      BBB+         6.36%      1.80      15.28%       4.32%    12.87%         22%                                      309
  20,171     48,643       3,699.09       BBB         6.51%      1.93      16.10%       4.43%    12.67%         29%                                      420
  25,171     43,643       3,318.86        BB-        9.10%      2.10      17.09%       6.19%    13.10%         37%
                                                                                                              0% 15% 22% 29% 37%                        733
                                                                                                                               Leverage
Optimal Cost of Capital:             12.67%
Change in firm value is a growing perpetuity = CF/(r-g) = cost savings/(discount rate-growth rate)         Assume                5%       growth
Annual cost savings = old firm value(Old cost of capital-New cost of capital) =                     593    million
Permanent increase in firm value = Annual cost savings/(cost of capital-growth rate) =           7,729     million
New firm value=old firm value + increase                                                        76,543     million
Estimated new share price = new equity value/new shares outstanding =                              15.2        up                     2      or       15.9%
   PV tax
 shield at
5% growth
       42    million
     2647    million
     4120    million
     5749    million
     9498    million
Corporate bond spreads: basis points over Treasury curve
Rating           1year      2year      3year     5year     7year   10year   30year
Aaa/AAA             40         45         50        60        74       85       96
Aa1/AA+             45         55         60        70        84       95      106
Aa2/AA              55         60         65        75        89      105      116
Aa3/AA-             60         65         70        85        99      117      136
A1/A+               70         80         90       105       119      142      159
A2/A                80         90        105       120       140      157      179
A3/A-               90        100        110       130       150      176      196
Baa1/BBB+          105        115        128       145       165      186      208
Baa2/BBB           120        130        140       160       180      201      221
Baa3/BBB-          140        145        155       172       193      210      232
Ba1/BB+            225        250        275       300       325      350      440
Ba2/BB             250        275        300       325       350      385      540
Ba3/BB-            300        350        375       425       445      460      665
B1/B+              375        400        425       500       550      610      765
B2/B               450        500        550       625       670      710      890
B3/B-              500        550        650       750       875      975    1075
Caa/CCC            600        650        800       900     1025     1150     1300
Typical Interest Coverage Ratios

>8.50
6.50-8.50
6.50-8.50
6.50-8.50
5.50-6.50
4.25-5.50
3.00-4.25
2.50-3.00
2.50-3.00
2.50-3.00
2.00-2.50
2.00-2.50
2.00-2.50
1.75-2.00
1.50-1.75
1.25-1.50
0.80-1.25

				
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