Capital Recapitalization Solved Questions
Please show your working step and step and thoroughly.
For the excel sheet, make sure you put the formula or how to calculate the result in each answer box.
HD’s business
HD was a large producer of branded appliances primarily used in residential households.
For the period 2015-2019 the industry posted modest annual unit sales growth of 1.8% despite
positive market conditions including a strong housing market and product innovations. Competition
from inexpensive imports and aggressive pricing by Mass Merchandisers Limited has reduced
growth to 2.5% annually over the period. Under its CEO Benjamin White’s leadership, HD operated
much as it always had, with three notable exceptions. First, the company completed an IPO (Initial
Public Offering) in 2014. This provided a measure of liquidity for founders’ descendants who,
collectively, owned 62% of the outstanding shares following the IPO. Second, beginning in the 2010s,
HD has gradually moved its production abroad. Finally, HD had undertaken a strategy focused on
rounding out and complementing its product offerings by acquiring small independent manufacturers
and/or the kitchen appliance product lines of large diversified manufacturers. Thus far, all
acquisitions had been for cash or HD stock.
HD’s historical performance
During the year ended December 31, 2019, HD earned net income of $8.25 billion on
revenue of $83.18 billion. Exhibits 1 and 2 present the company’s recent financial statements.
The company’s 2019 EBIT margin of nearly 7.0% was average within the peer group. During 2015-
2019, compounded annual returns for HD shareholders (including dividends and stock price
appreciation) was approximately 11.1% per year. This was higher than the ASX S&P200, which
returned approximately 5% per year. However, it was well below the 16% annual compounded return
earned by shareholders of HD’s peer group during the same period.
HD’s financial policies
HD’s financial position was conservative and very much in keeping with HD’s longstanding practice and, with its management style. In recent years the company’s largest uses of cash have been common dividends and cash consideration paid in various acquisitions. Dividends per
share had risen only modestly during 2015-2019. However, as the company issued new shares in
connection with some of its acquisitions, the number of shares outstanding increasesd to
approximately 1.27 billion by the end of 2019.
31/12/2019
Net income (000s) 8,248,000
Average number of shares outstanding (000s) 1,267,881
Effective corporate tax rate 36.50%
Average cost of bonds 2.1%
On a bright Friday afternoon, Benjamin sat in his office reflecting on a meeting he had with
an investment banker earlier in the week. The banker, whom Benjamin had known for years, asked
for the meeting after a group of private equity investors made discreet inquiries about a possible
acquisition of HD. Although HD was a public company, a majority of its shares were controlled by
family members descended from the firm’s founders together with various family trusts. Benjamin
knew the family had no current interest in selling – on the contrary, HD was interested in acquiring
other companies in the same industry – so this overture, like a few others before it, would be politely
rebuffed.
Nevertheless, Benjamin was struck by the banker’s assertion that a private equity buyer
could “unlock” value inherent in HD’s strong operations and balance sheet. Using cash on HD’s
balance sheet and new borrowings, a private equity firm could purchase all of HD’s outstanding
shares at a price higher than its current stock price of $114.33 per share. It would then repay the debt
over time using the company’s future earnings. The banker pointed out that HD itself could do the
same thing – borrow money to buy back its own shares. In the days since the meeting, Benjamin’s
thoughts kept returning to a share repurchase. Working as the analyst for the company, you are asked
to prepare a report to explain the pros and cons of this deal. Here is a draft of your report.
Draft report – an analysis on capital structure and firm value
Capital structure in perfect markets vs. with taxes (11 Mark)
In preparing the report, you decide to start from the scenario where the capital markets are perfect.
Using Excel spreadsheets, you complete the following:
1. Compute the market debt to equity (D/E) ratio, the cost of equity (rE) and the weighted average
cost of capital (WACC) for HD. It is assumed the cost of unlevered equity (rU) is 14.8%.
Page 3 of 7 Sem 2 2020 Joey Yang
(Hint: the market value of debt is the sum of Long Term Debt and Short Term Debt/Current Portion
of Long Term Debt subtracting Cash and Cash Equivalents from the balance sheet. Use market value
of equity.)
2. Repeat the above assuming that market frictions exist, such as corporate tax.
3. Compare results in the above two questions, and use MM theory to explain the effect of capital
structure on the equity cost of capital and WACC a) in perfect markets; and b) when corporate
tax exists. (No calculation is needed.)
A Levered recapitalization (12 Mark)
Next you show Benjamin the impact of the investment banker’s share repurchase proposal: the
company could raise $10 billion new debt at the current rate of 2.1% to repurchase its own shares.
4. Assuming the firm plans to keep this new debt outstanding forever, calculate the present value
of the interest tax shield (ITS) of the new debt.
5. Compute the market value of the equity, the share price, and the number of shares outstanding,
at the time of the announcement for the repurchase and after the repurchase is complete,
respectively (assume no arbitraging).
6. Use the above analysis to explain whether this repurchase is a good deal. Discuss how this deal
has affected the total value of the company.
Payout policy (4 Mark)
7. Given that HD currently has an 80% dividend payout policy, you also show the interest income
to lenders, and dividend income to shareholders, assuming both types of investors pay personal
tax at 40% in each of the following tax environment: 1) the classic tax system; and 2) the
imputation tax system. Explain which tax system is preferable theoretically.
The downside of leverage (3 Mark)
8. Benjamin also requires you to include a discussion on the possible downside of this deal
(leveraged recapitalization) that the executives of HD should be aware of.
