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Your boss was impressed with your presentation regarding the irrelevance of capital structure from Chapter 14 but, as expected, has realized that market imperfections like taxes must be accounted for. You have now been asked to include taxes in your analysis. Your boss knows that interest is deduct- ible and has decided that the stock price of Home Depot should increase if the firm increases its use of debt. Thus, your boss wants to propose a share repurchase program using the proceeds from a new debt issue and wants to present this plan to the CEO and perhaps to the Board of Directors.
Your boss would like you to examine the impact of two different scenarios, adding a modest level of debt and adding a higher level of debt. In particular, your boss would like to consider issuing $1 billion in new debt or $5 billion in new debt. In either case, Home Depot would use the proceeds to repurchase stock.
1.
Using the financial statements for Home Depot that you downloaded in Chapter 14, determine the average corporate tax rate for Home Depot over the last four years by dividing Income Tax by Earnings before Tax for each of the last four years.
2.
Begin by analyzing the scenario with $1 billion in new debt. Assuming the firm plans to keep this new debt outstanding forever, determine the present value of the tax shield of the new debt. What additional assumptions did you need to make for this calculation?
3.
Determine the new stock price if the $1 billion in debt is used to repurchase stock.
a. Use the current market value of Home Depot’s equity that you calculated in Chapter 14.
b. Determine the new market value of the equity if the repurchase occurs.
c. Determine the new number of shares and the stock price after the repurchase is announced.
4.
What will Home Depot’s D/E ratio based on book values be after it issues new debt and repur- chases stock? What will its market value D/E ratio be?
5.
Repeat Steps 2–4 for the scenario in which Home Depot issues $5 billion in debt and repurchases stock.
6.
Based on the stock price, do the debt increase and stock repurchase appear to be a good idea?
Why or why not? What issues might the executives of Home Depot raise that aren’t considered in your analysis?