Leverage Case Study

by | Mar 13, 2021 | Business Studies, Case Study, College (3-4)

Choose a firm on Yahoo Finance with 3 years of balance sheet and income statement data to analyze, with Total Debt / Total Assets < 20% to allow room for a recapitalization. For the purposes of this case, assume the firm is financed with only debt and common equity. Assume all Stockholder’s Equity is made up of common shares, and that all Debt is of the same maturity. (That is, add all Debt together, regardless of maturity. Treat Preferred Equity as Common Stockholder’s Equity.)

You are assisting the CFO of the firm of your choice in analyzing a potential recapitalization to increase firm value. Your CEO has realized the value of taking on debt in the current interest rate environment to boost shareholder value of your equity-funded firm. The CFO has asked you to run the numbers on the potential recap and prepare a report recommending a course of action.

The recapitalization will increase the weight of debt in the firm’s WACC by either 10%, 15%, or 20% by issuing new bonds as Long-Term Debt.1 This amount can be used to repurchase shares, or as a one-time special dividend to shareholders to complete the recapitalization. Doing this will change your firm’s share value, credit rating, WACC, key financial ratios such as debt coverage2 , earnings per share, and corporate control.

Since the firm is considering adding somewhere between 10% and 20% additional debt, how much additional debt do you recommend the firm to take on? Your answer can be one of the 10%, 15%, and 20% alternatives for an increase, or 0% if you advise against the recapitalization. You must justify your answer.

Current WACC

Calculate your initial firm’s WACC using the latest Balance Sheet data. You may use the Beta from Yahoo Finance. The CFO’s office uses the 10-year Tbond yield as the risk-free rate and 7% as the market risk premium for CAPM calculations. You may estimate a before-tax cost of debt as Interest Expense / Total Debt, but make sure this is a reasonable number (above the risk-free Tbond yield). If this is too low, you may use industry average cost of debt.3 This should give you sufficient data to calculate the firm’s WACC prior to any capital structure changes.

Current Cash Flows

Back out the implied cash flow by solving for it from the perpetuity version of the CH15 Value of the Firm equation. Here you may use the book value of the firm as Total Debt + Total Equity for V.
4Make a realistic assumption about your firm’s growth rate g

𝑉 = 𝐹𝐶𝐹(1+𝑔)

Assume the value of FCF will remain constant for the foreseeable future. You may assume the higher level of leverage will not have any material effects on FCF until you reach the 50% leverage point. Make qualitative adjustments as necessary.

WACC Effects From Recapitalization

If you perform the recapitalization, you need to know how risky your firm currently is, and how much more risky it will become. The credit rating on your current debt needs to be calculated, as does the new cost of debt, equity, and WACC post-recap. You will need to do scenario analysis on the Income Statement observing the resulting variation in several key financial ratios such as debt coverage to determine the most appropriate current debt rating and likelihood of bankruptcy (see Exh 1). Assume reasonable
probabilities and deviations from the baseline scenario Income Statement as in lecture. If your firm
currently has no debt, you may assume it is AA-rated.
Once you have the current bond rating, use Exh to find your new post-recap cost of debt depending on
the increase in leverage from the recapitalization by multiplying your current cost of debt by the
appropriate factor.

If your firm has no current debt, you may use the cost of debt from a comparable competitor firm as a proxy for your current cost of debt. You may assume that three possible levels of recapitalization are under consideration, with corresponding increases to the weight of debt wd:

+.10 increase in wd
+.15 increase in wd
+.20 increase in wd

You will also need to re-lever your firm’s Beta given your new level of leverage. Use the same CAPM assumptions as before. Calculate the cost of equity, and combine it with your calculated cost of debt to get your firm’s new WACC. Use the updated WACC to get the updated value of the firm from Equation 1 for each possible level of leverage. Recommend the optimal capital structure to seek during the recapitalization.
You should also discuss qualitative issues from CH15 as they apply to the risk level of the firm, where appropriate.

Earnings Per Share Effects

Calculate the EPS under both the share repurchase and dividend payout alternatives for the recap. You
may assume that FCF = NOPAT = EBIT(1-T) and that Earnings is EBIT minus interest and minus taxes. Use
the number of shares outstanding from Yahoo Finance.

Corporate Control Effects

Assume your firm’s Stockholder’s Equity is split up into two share classes. Class A common stock,
comprising 95% of your firm’s Total Stockholder’s Equity, is standard common stock with 1 vote per share.
Class B makes up the other 5% and is like Class A common stock in most respects, but each share has 10
votes each. The CEO/owner of your firm controls 15% of Class A common shares outstanding, and 90%
of the Class B shares. He wants to make sure his control of the firm is not affected by the recapitalization.
Conduct an analysis of the proposed recap of the firm taking the above issues into account. Make sure to
address each one, and to do scenario and sensitivity analysis. Some questions below will guide your

  1. What is the CFO hoping to accomplish with the recap strategy?
  2. How is using the issued debt to pay a dividend similar to, and different from, a stock repurchase?
  3. What effect would the new debt issue and dividend/repurchase have on
    a. The firm’s outstanding shares
    b. value of the firm’s equity
    c. price per share / earnings per share
    d. debt interest coverage ratios and financial flexibility?
  4. What is the current pre-recap credit rating and WACC? What is the implied cash flow?
  5. Find the optimal size of the recap between the three (or four) alternatives considered and produce the
    “anatomy” of the optimal recap per lecture slides.
  6. What is the post-recap credit rating and WACC? (Would you expect it to be higher?) What is the new
    firm value?
  7. Conduct sensitivity and scenario analysis on firm value V
    Does your firm ever go bankrupt? (Is rd > EBIT/TA in any reasonable case?)
    What variables are most important for the bond rating?
    What about for firm value?
    Does your cost of debt or firm value calculation need risk-adjusting?
  8. How might the shareholders perceive this recap? What about the CEO/owner? Does it depend on the
    way it is conducted? (Dividend vs repurchase)
  9. Based on these, and any other material considerations, should the CFO try to convince the firm’s
    directors to undertake this recap? If so, how much additional debt do you recommend the firm to take

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