PRELIMINARY STUFF AND INPUTS

Objective This spreadsheet allows you to compute the optimal capital structure for a non-financial
service firm. If you have a financial service firm use capstrfin.xls
Before you starOpen preferences in excel, go into calculation options and put a check in the iteration box.
If it is already checked, leave it as is.
Inputs The inputs are primarily in the input sheet. If your company has operating leases,
use the operating lease worksheet to enter your lease or rental commitments.
Units Enter all numbers in the same units (000s, millions or even billions)
Income inputs The key income inputs are EBITDA, depreciation and amortization and interest expenses.
Enter the most updated numbers you have for each (even if they are 12-month trailing
numbers). If the most recent period for which you have data has an operating income that
is abnormal, either because of extraordinary losses/gains or some other occurrence, use
an average operating income over the last few years.
From the statement of cash flows, also enter the capital spending from the recent period.
P.S: If you have negative operating income and you expect to continue having negative
operating income, your optimal debt ratio will be zero.
Balance Sheet Enter the book value of all interest-bearing debt. If you have a market value enter that
number. Alternatively, input the average maturity of the debt and I will estimate the
market value of debt.
Market Data Enter the current stock price, the current long-term government bond rate, the risk
premium you would like to use to estimate your cost of equity and the current rating for
your firm. If you do not have a rating, there is an option for you at the very bottom of
the spreadsheet to compute a synthetic rating.
Tax Rate Enter a marginal tax rate, if you can estimate it. Otherwise, use the effective tax rate.
Default SpreadThis spreadsheet has interest coverage ratios, ratings and default spreads built into it in
the worksheet. This spreadsheet treats the imputed interest expense on operating leases as part of the
interest expense when computing the interest coverage ratio. You can choose between ratings for large firms
(firms with market capitalizations that exceed $ 5 billion is a simple cut off but you can deviate from it)
a more conservatve for small or risky firms. If you want, you can change the interest
coverage ratios and ratings in these tables.
READING THE OUTPUT
Summary The summary provides a picture of your firm's current cost of capital and debt ratio, and
compares it to your firm's value at every debt raito, incorporating the tax benefits from debt & the expected
bankruptcy costs at each level of debt.
Details The details of the calculation at each debt ratio are below the summary.

References
Corporate Finance: Theory and Practice, Chapter 18
Applied Corporate Finance: Chapter 8
gs for large firms

& the expected

Question Answer
Q1: What do I do excel says there are circ Go into preferences, choose calculation options and make sure the iteration box has a check in it.
Q2: My spreadsheet has gone crazy. I get erI am sorry to say this, but you probably just made an input error. While you might have
What did I do wrong? fixed it, the iterations in the spreadsheet make it very sensitive and the errors will not
go away. The only fix (Sorry, sorry…) is to copy the inputs into a fresh version of the spreadshee
Q3: I am entering the inputs for my compaYou probably forgot to check the iteration box (see Q1)
optimal numbers do not seem to change from the
originals
Q4: I am getting an optimal debt ratio of 0Sure. If your operating income is either negative or very low, relative to your firm value,
be right. Can it? you can end up at an optimal debt ratio of 0%. For instance, if you have EBIT of 100 on a
firm value of 10000, a 10% debt ratio would probably push you into a C rating and give
you a very high cost of capital.
 the iteration box has a check in it.
or. While you might have
and the errors will not
o a fresh version of the spreadsheet.

elative to your firm value,

you have EBIT of 100 on a
u into a C rating and give
Inputs
Please enter the name of the company you are analyzing: Hormel

Date of analysis 22-Apr-13

Financial Information
Earnings before interest, taxes and depreciation (EBITDA) $635.00

Depreciation and Amortization: $126.00

Capital Spending: $126.00
Interest expense on debt: $28.00
Tax rate on ordinary income: 40.00%
Cost of Bankrtupcy as a percent of market value of firm = 25.00%
Current Rating on debt (if available): Aaa/AAA

Interest rate based upon rating: 2.75%

Market Information

Number of shares outstanding: 134.526

Market price per share: $31.08
Beta of the stock: 0.83

Book value of debt: $ 450.00

Can you estimate the market value of the outstanding debt? No

If so, enter the market value of debt:

Do you want me to try and estimate market value of debt? Yes

If yes, enter the average maturity of outstanding debt? 0.00

Do you have any operating leases? Yes

General Market Data
Current long-term (LT) government bond rate: 2.35% (in percent)
Risk premium (for use in the CAPM) 6.00% (in percent)
Country default spread (for cost of debt) 0.00%

General Data
Which spread/ratio table would you like to use for your anlaysis? 2

Do you want to assume that existing debt is refinanced at the 'new' ra Yes (Yes or No)
Do you want the firm's current rating to be adjusted to the synthetic r Yes (Yes or No)
 Operating Lease Converter
Operating lease expenses are really financial expenses, and should be treated as such. Accounting standards allow th
be treated as operating expenses. This program will convert commitments to make operating leases into debt and
adjust the operating income accordingly, by adding back the imputed interest expense on this debt.

Inputs
Operating lease expense in current year = $21.90
Operating Lease Commitments (From footnote to financials)
Year Commitment ! Year 1 is next year, ….
1 $ 10.00
2 $ 8.07
3 $ 6.76
4 $ 5.21
5 $ 4.51
6 and beyond $ 11.94

Pre-tax Cost of Debt = 2.75% ! If you do not have a cost of debt, use the attached ratings estimator

From the current financial statements, enter the following

Reported Operating Income (EBIT) = $509.00 ! This is the EBIT reported in the current income statement
Reported Interest Expenses = $28.00
Output
Number of years embedded in yr 6 estim 1 ! I use the average lease expense over the first five years
to estimate the number of years of expenses in yr 6
Converting Operating Leases into debt
Year CommitmentPresent Value
1 $ 10.00 $9.73
2 $ 8.07 $7.64
3 $ 6.76 $6.23
4 $ 5.21 $4.67
5 $ 4.51 $3.94
6 and beyond $ 11.94 $10.15 ! Commitment beyond year 6 converted into an annuity for ten years
Debt Value of leases = $ 42.37

Restated Financials
Operating Income with Operating leases reclassified as debt = $ 530.90
Interest expenses with Operating leases classified as debt = $ 29.17
counting standards allow them to
ing leases into debt and
Inputs for synthetic rating estimation
Enter the type of firm = 2 (Enter 1 if large manufacturing firm, 2 if smaller or riskier firm, 3 if financial service firm)
Enter current Earnings before interest and taxes (EBIT) = $530.90 (Add back only long term interest expense for financia
Enter current interest expenses = $29.17 (Use only long term interest expense for financial firm
Enter current long term government bond rate = 2.35%
Output
Interest coverage ratio = 18.20
Estimated Bond Rating = Aaa/AAA
Estimated Default Spread = 0.40%
Estimated Cost of Debt = 2.75%

For large or stable firms

If interest coverage ratio is
> ≤ to Rating is Spread isBankruptcy Probability
-100000 0.199999 D2/D 12.00% 100%
0.2 0.649999 C2/C 10.00% 85%
0.65 0.799999 Ca2/CC 8.00% 70.00%
0.8 1.249999 Caa/CCC 7.00% 59.01% C2/C
1.25 1.499999 B3/B- 6.00% 45.00%
1.5 1.749999 Ba1/BB+ 5.00% 36.80%
1.75 1.999999 Ba2/BB 4.00% 25.00%
2 2.2499999 B1/B+ 3.25% 16.63%
2.25 2.49999 B2/B 2.75% 10.00%
2.5 2.999999 Baa2/BBB 1.75% 7.54%
3 4.249999 A3/A- 1.20% 2.50%
4.25 5.499999 A2/A 1.00% 0.66%
5.5 6.499999 A1/A+ 0.90% 0.60%
6.5 8.499999 Aa2/AA 0.70% 0.51%
8.50 100000 Aaa/AAA 0.40% 0.07%

For smaller and riskier firms

If interest coverage ratio is
greater than ≤ to Rating is Spread isBankruptcy Probability
-100000 0.499999 D2/D 12.00% 100%
0.5 0.799999 C2/C 10.00% 85%
0.8 1.249999 Ca2/CC 8.00% 70.00%
1.25 1.499999 Caa/CCC 7.00% 59.01%
1.5 1.999999 B3/B- 6.00% 45.00%
2 2.499999 Ba1/BB+ 5.00% 36.80%
2.5 2.999999 Ba2/BB 4.00% 25.00%
3 3.499999 B1/B+ 3.25% 16.63%
3.5 3.9999999 B2/B 2.75% 10.00%
4 4.499999 Baa2/BBB 1.75% 7.54%
4.5 5.999999 A3/A- 1.20% 2.50%
 6 7.499999 A2/A 1.00% 0.66%
7.5 9.499999 A1/A+ 0.90% 0.60%
9.5 12.499999 Aa2/AA 0.70% 0.51%
12.5 100000 Aaa/AAA 0.40% 0.07%
ancial service firm)
interest expense for financial firms)
st expense for financial firms)
 CAPITAL STRUCTURE 11

Hormel
22-Apr-13
Capital Structure Financial Market Income Statement
Current MV of Equity = $4,181 Current Beta for Stock = 0.83 Current EBITDA =
Market Value of interest- $450 Current Bond Rating = Aaa/AAA Current Depreciation =
# of Shares Outstanding = 134.526 Summary of Inputs Current Tax Rate =
Debt Value of Operating le $42 Long Term Government Bond Rate 2.35% Current Capital Spending=
Risk Premium = 6.00% Pre-tax cost of debt = 2.75% Current Interest Expense =

Maximum firm $5,403

Optimal debt ra 50.00%
Adjusted Present Value Estimates
Debt Ratio $ Debt Unlevered firm value
Tax Benefits from Expected
Debt Bankruptcy Cost
0% $0 $4,477 $0 $1
10% $467 $4,477 $187 $1
20% $935 $4,477 $374 $1
30% $1,402 $4,477 $561 $6
40% $1,869 $4,477 $748 $8
50% $2,337 $4,477 $935 $9
60% $2,804 $4,477 $1,122 $350
70% $3,271 $4,477 $1,309 $651
80% $3,739 $4,477 $1,495 $672
90% $4,206 $4,477 $1,682 $1,078

We use the following default spreads in our analysis. Change them in the input sheet if necessary:
Rating Coverage gt and lt Spread Default Probability
AAA 12.5 100000 0.40% 0.07%
AA 9.5 12.499999 0.70% 0.51%
A+ 7.5 9.499999 0.90% 0.60%
A 6 7.499999 1.00% 0.66%
A- 4.5 5.999999 1.20% 2.50%
BBB 4 4.499999 1.75% 7.54%
BB 3 3.499999 3.25% 16.63%
B+ 2.5 2.999999 4.00% 25.00%
B 2 2.499999 5.00% 36.80%
B- 1.5 1.999999 6.00% 45.00%
CCC 1.25 1.499999 7.00% 59.01%
CC 0.8 1.249999 8.00% 70.00%
C 0.5 0.799999 10.00% 85.00%
D -100000 0.499999 12.00% 100.00%
 CAPITAL STRUCTURE 12

Current b 0.83 Current Equity= $4,181 Current Depreciation

Current $492 Current EBITDA= $657 Current Interest rate (Comp
Tax rate= 40.00% Current Rating= Aaa/AAA Current T.Bond rate=

WORKSHEET FOR ESTIMATING RATINGS/INTEREST RATES

D/(D+E) 0.00% 10.00% 20.00% 30.00% 40.00% 50.00%
D/E 0.00% 11.11% 25.00% 42.86% 66.67% 100.00%
$ Debt $0 $467 $935 $1,402 $1,869 $2,337
Beta 0.78 0.83 0.89 0.97 1.09 1.24
Cost of E 7.00% 7.31% 7.70% 8.20% 8.86% 9.79%

EBITDA $657 $657 $657 $657 $657 $657

Deprecia $126 $126 $126 $126 $126 $126
EBIT $531 $531 $531 $531 $531 $531
Interest $0 $13 $26 $43 $61 $78
Taxable $531 $518 $505 $488 $470 $453
Tax $212 $207 $202 $195 $188 $181
Net Inco $319 $311 $303 $293 $282 $272
(+)Depre $126 $126 $126 $126 $126 $126
Funds fr $445 $437 $429 $419 $408 $398

Pre-tax I ∞ 41.31 20.65 12.42 8.74 6.78

Funds/De ∞ 0.93 0.46 0.30 0.22 0.17
Likely Ra AAA Aaa/AAA Aaa/AAA Aa2/AA A1/A+ A2/A
Pre-tax c 2.75% 2.75% 2.75% 3.05% 3.25% 3.35%
Probabili 0.07% 0.07% 0.07% 0.51% 0.60% 0.66%
Eff. Tax 40.00% 40.00% 40.00% 40.00% 40.00% 40.00%

Interest cov Interest cov RATING Interest rate

Low High
-100000 0.499999 D2/D 14.35%
0.5 0.799999 C2/C 12.35%
0.8 1.249999 Ca2/CC 10.35%
1.25 1.499999 Caa/CCC 9.35%
1.5 1.999999 B3/B- 8.35%
 CAPITAL STRUCTURE 13

2 2.499999 Ba1/BB+ 7.35%

2.5 2.999999 Ba2/BB 6.35%
3 3.499999 B1/B+ 5.60%
3.5 3.9999999 B2/B 5.10%
4 4.499999 Baa2/BBB 4.10%
4.5 5.999999 A3/A- 3.55%
6 7.499999 A2/A 3.35%
7.5 9.499999 A1/A+ 3.25%
9.5 12.499999 Aa2/AA 3.05%
12.5 100000 Aaa/AAA 2.75%

Adjusted Present Value Approach

Current Value of the Firm = $4,673

- Tax Benefit on Current Debt = $197 Cost of Bankruptcy (% of Value) =
+ Expected Current Bankruptcy Cost = $1 Current Probability of Bankrupcy =

Unlevered Value of Firm = $4,477

Debt Ratio 0.00% 10.00% 20.00% 30.00% 40.00% 50.00%

$ Debt $0 $467 $935 $1,402 $1,869 $2,337

Unlev. F $4,477 $4,477 $4,477 $4,477 $4,477 $4,477

Tax Benef $0 $187 $374 $561 $748 $935

Bond Rat AAA Aaa/AAA Aaa/AAA Aa2/AA A1/A+ A2/A
Prob. of 0.07% 0.07% 0.07% 0.51% 0.60% 0.66%

Bankrupt $1 $1 $1 $6 $8 $9
Index var 0 0 0 0 0 1

Levered $4,477 $4,663 $4,850 $5,032 $5,217 $5,403

Debt Ratio $ Debt Tax Rate Unlevered Firm Val Tax Benefits Bond Rating Probability of Defaul
0% $0 40.00% $4,477 $0 AAA 0.07%
10% $467 40.00% $4,477 $187 Aaa/AAA 0.07%
20% $935 40.00% $4,477 $374 Aaa/AAA 0.07%
30% $1,402 40.00% $4,477 $561 Aa2/AA 0.51%
40% $1,869 40.00% $4,477 $748 A1/A+ 0.60%
50% $2,337 40.00% $4,477 $935 A2/A 0.66%
60% $2,804 40.00% $4,477 $1,122 Ba2/BB 25.00%
70% $3,271 40.00% $4,477 $1,309 B3/B- 45.00%
80% $3,739 40.00% $4,477 $1,495 B3/B- 45.00%
90% $4,206 40.00% $4,477 $1,682 Ca2/CC 70.00%
 CAPITAL STRUCTURE 14

$657
nt Depreciation = $126
40.00%
nt Capital Spending= $126
nt Interest Expense = $29

Levered Firm Value

$4,477
$4,663
$4,850
$5,032
$5,217
$5,403
$5,249
$5,135
$5,301
$5,082

Ratings comparison at current debt ratio

Current Interest coverage ratio = 18.20
Rating based upon coverage = Aaa/AAA
Interest rate based upon coverage = 2.75%
Current rating for company = Aaa/AAA
Current interest rate on debt = 2.75%
Current Bankruptcy Probability = 0.07%
 CAPITAL STRUCTURE 15

Current Depreciation= $126

Current Interest rate (Company)= 2.75%
Current T.Bond rate= 2.35%

NTEREST RATES
60.00% 70.00% 80.00% 90.00%
150.00% 233.33% 400.00% 900.00%
$2,804 $3,271 $3,739 $4,206
1.47 1.86 2.64 4.96
11.19% 13.51% 18.16% 32.12%

$657 $657 $657 $657

$126 $126 $126 $126
$531 $531 $531 $531
$178 $273 $312 $435
$353 $258 $219 $96
$141 $103 $87 $38
$212 $155 $131 $57
$126 $126 $126 $126
$338 $281 $257 $183

2.98 1.94 1.70 1.22

0.12 0.09 0.07 0.04
Ba2/BB B3/B- B3/B- Ca2/CC
6.35% 8.35% 8.35% 10.35%
25.00% 45.00% 45.00% 70.00%
40.00% 40.00% 40.00% 40.00%

Bankruptcy
Probability
100.00%
85.00%
70.00%
59.01%
45.00%
 CAPITAL STRUCTURE 16

36.80%
25.00%
16.63%
10.00%
7.54%
2.50%
0.66%
0.60%
0.51%
0.07%

ach

25%
0.07%

60.00% 70.00% 80.00% 90.00%

$2,804 $3,271 $3,739 $4,206

$4,477 $4,477 $4,477 $4,477

$1,122 $1,309 $1,495 $1,682

Ba2/BB B3/B- B3/B- Ca2/CC
25.00% 45.00% 45.00% 70.00%

$350 $651 $672 $1,078

0 0 0 0

$5,249 $5,135 $5,301 $5,082

Expected BankruptcyValue of Levered Firm

$1 $4,477
$1 $4,663
$1 $4,850
$6 $5,032
$8 $5,217
$9 $5,403
$350 $5,249
$651 $5,135
$672 $5,301
$1,078 $5,082
 Rating is Yes/No IBC Type of firm
Aaa/AAA Yes High 1
Aa2/AA No Medium 2
A1/A+ Low
A2/A
A3/A-
Baa2/BBB
Ba1/BB+
Ba2/BB
B1/B+
B2/B
B3/B-
Caa/CCC
Ca2/CC
C2/C
D2/D