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 start Open 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 Spreads This 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 optimal debt ratio and the cost of capital at that level. It then
uses the savings from the change in cost of capital to compute how much your firm value
will change:
- with constant savings: as the present value of a perpetuity
- with a growth rate in the savings in perpetuity
The firm value change, divided by the number of shares, yields a price change
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
s as part of the
ratings for large firms
n deviate from it)
Question
Q1: What do I do excel says there are circular references?
Q2: My spreadsheet has gone crazy. I get errors all over.
What did I do wrong?

Q3: I am entering the inputs for my company but the

optimal numbers do not seem to change from the
originals
Q4: I am getting an optimal debt ratio of 0%. This can't
be right. Can it?

Q5: My cost of capital at my optimal debt ratio is higher

than the current cost of capital. I thought it was supposed
to be lower.
Answer
Go into preferences, choose calculation options and make sure the iteration box has a check in it.
I am sorry to say this, but you probably just made an input error. While you might have
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 spreadsheet.
You probably forgot to check the iteration box (see Q1)

Sure. If your operating income is either negative or very low, relative to your firm value,
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.
Generally, you are right. However, I would suggest that you look at three factors:
- If your optimal is just slightly higher or lower than your current debt ratio, it is possible that you
are closer to the optimal than the stated optimal. Let me explain. Assume that you are at a 24% debt ratio
and the optimal comes out to 30%. The true optimal is really somewhere around 30% since
I am constrained to work in 10% increments of the debt ratio. If the true optimal were
26%, your current debt ratio of 24% is closer to the optimal.
- Rating Differences: One of the costs of rating a company based only on the interest
coverage ratio is that the rating might be very different from the actual rating. Thus, your
current cost of capital is based upon your current rating, and the optimal is based upon
the synthetic ratings, and the two don't match, the current and the optimal cost of capital
can be mismatched. You can get around this by switching to a synthetic rating for computing
the current cost of capital (in the input sheet).
- Existing debt at low rates: I assume in the spreadsheet that existing debt gets refinanced at
the new pre-tax cost of debt at each debt ratio. Consequently, if you have a lot of old debt on
your books at much lower rates, the interest expense that I report will be much higher than
your actual interest expense. This, in turn, can affect your interest coverage ratio and rating.
This, too, you can fix by locking in debt at current rates in the input sheet.
Inputs
Please enter the name of the company you are analyzing: Lexmark

Financial Information

Earnings before interest, taxes and depreciation (EBITDA) $767.80

Depreciation and Amortization: $200.90

Capital Spending: $200.20

Interest expense on debt: $22.10

Tax rate on ordinary income: 27.40%

Current Rating on debt (if available): AAA

Interest rate based upon rating: 5.00%

Market Information

Number of shares outstanding: 103.5

Market price per share: $54.81

Beta of the stock: 1.27

Book value of debt: $149.80

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? No

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: 4.65%

Risk premium (for use in the CAPM) 4.80%

Country default spread (for cost of debt) 0.00%

General Data

Which spread/ratio table would you like to use for your analysis? 1

Do you want to assume that existing debt is refinanced at the 'new' rate? Yes

Do you want the firm's current rating to be adjusted to the synthetic rating? Yes
(in percent)

(in percent)

(Yes or No)

(Yes or No)
 Operating Lease Converter
Operating lease expenses are really financial expenses, and should be treated as such. Accounting standards allow the
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 = $36.90
Operating Lease Commitments (From footnote to financials)
Year Commitment ! Year 1 is next year, ….
1 $28.40
2 $21.40
3 $16.30
4 $9.90
5 $16.90
6 and beyond $16.90

Pre-tax Cost of Debt = #VALUE! ! 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) = $566.90 ! This is the EBIT reported in the current income statement
Reported Interest Expenses = $22.10
Output
Number of years embedded in yr 6 estimate = 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 Commitment Present Value
1 $28.40 #VALUE!
2 $21.40 #VALUE!
3 $16.30 #VALUE!
4 $9.90 #VALUE!
5 $16.90 #VALUE!
6 and beyond $16.90 #VALUE! ! Commitment beyond year 6 converted into an annuity for ten years
Debt Value of leases = #VALUE!

Restated Financials
Operating Income with Operating leases reclassified as debt = #VALUE!
Interest expenses with Operating leases classified as debt = #VALUE!
 Lease Converter
s such. Accounting standards allow them to
ake operating leases into debt and
xpense on this debt.

he attached ratings estimator

orted in the current income statement

se expense over the first five years

r of years of expenses in yr 6

into an annuity for ten years

Inputs for synthetic rating estimation
Enter the type of firm = 1 (Enter 1 if large manufacturing firm, 2 if smaller or riskier firm, 3 if financial service f
Enter current Earnings before interest and taxes (EBIT) = #VALUE!
Enter current interest expenses = #VALUE!
Enter current long term government bond rate = 4.65%
Output
Interest coverage ratio = #VALUE!
Estimated Bond Rating = #VALUE!
Estimated Default Spread = #VALUE!
Estimated Cost of Debt = #VALUE!

For large or stable firms

If interest coverage ratio is
> ≤ to Rating is Spread is
-100000 0.2 D 20.00%
0.2 0.65 C 15.00%
0.65 0.8 CC 12.00%
0.8 1.25 CCC 10.00%
1.25 1.5 B- 8.50%
1.5 1.75 B 7.25%
1.75 2 B+ 6.00%
2 2.25 BB 5.00%
2.25 2.5 BB+ 4.25%
2.5 3 BBB 3.50%
3 4.25 A- 3.00%
4.25 5.5 A 2.50%
5.5 6.5 A+ 2.25%
6.5 8.5 AA 1.75%
8.50 100000 AAA 1.25%

For smaller and riskier firms

If interest coverage ratio is
greater than ≤ to Rating is Spread is
-100000 0.5 D 20.00%
0.5 0.8 C 15.00%
0.8 1.25 CC 12.00%
1.25 1.5 CCC 10.00%
1.5 2 B- 8.50%
2 2.5 B 7.25%
2.5 3 B+ 6.00%
3 3.5 BB 5.00%
3.5 4 BB+ 4.25%
4 4.5 BBB 3.50%
4.5 6 A- 3.00%
6 7.5 A 2.50%
7.5 9.5 A+ 2.25%
9.5 12.5 AA 1.75%
12.5 100000 AAA 1.25%
smaller or riskier firm, 3 if financial service firm)
(Add back only long term interest expense for financial firms)
(Use only long term interest expense for financial firms)
 CAPITAL STRUCTURE 17

Lexmark
Capital Structure Financial Market Income Statement
Current MV of Equity = $5,673 Current Beta for Stock = 1.27 Current EBITDA = #VALUE!
Market Value of interest-bearing debt =$150 Current Bond Rating = AAA Current Depreciation = $201
# of Shares Outstanding = 103.5 Summary of Inputs Current Tax Rate = 27.40%
Debt Value of Operating leases (if any)
#VALUE! Long Term Government Bond Rate4.65%
= Current Capital Spending= $200
Risk Premium = 4.80% Pre-tax cost of debt = 5.00% Current Interest Expense = #VALUE!

RESULTS FROM ANALYSIS

Current Optimal Change
D/(D+E) Ratio = #VALUE! #VALUE! #VALUE!
Implied Growth Rate Calculation
Beta for the Stock = 1.27 #VALUE! #VALUE! Value of Firm = #VALUE!
Cost of Equity = 10.75% #VALUE! #VALUE! Current WACC = #VALUE!
Current FCFF = #VALUE! ! I am ignoring working capital
AT Interest Rate on Debt = #VALUE! #VALUE! #VALUE! Implied Growth Rate #VALUE!
=
If this number is >Riskfree rate, I use the riskfree rate as a perpetual growth rate
WACC #VALUE! #VALUE! #VALUE!
Implied Growth Rate = #VALUE!
Assumes constant saving Firm Value (no growth) = #VALUE! #VALUE! #VALUE!
Assumes perpeutal growth Firm Value (Perpetual Growth) =#VALUE! #VALUE! #VALUE!
Value/share (No Growth) = #VALUE! #VALUE! #VALUE!
Value/share (Perpetual Growth) =#VALUE! #VALUE! #VALUE!

We use the following default spreads in our analysis. Change them in the input sheet if necessary: Ratings comparison at current debt ratio
Rating Coverage gt and lt Spread Current Interest coverage ratio = #VALUE!
AAA 8.5 100000 1.25% Rating based upon coverage = #VALUE!
AA 6.5 8.5 1.75% Interest rate based upon coverage = #VALUE!
A+ 5.5 6.5 2.25% Current rating for company = AAA
A 4.25 5.5 2.50% Current interest rate on debt = 5.00%
A- 3 4.25 3.00%
BBB 2.5 3 3.50%
BB 2 2.25 5.00%
B+ 1.75 2 6.00%
B 1.5 1.75 7.25%
B- 1.25 1.5 8.50%
CCC 0.8 1.25 10.00%
CC 0.65 0.8 12.00%
C 0.2 0.65 15.00%
D -100000 0.2 20.00%
 CAPITAL STRUCTURE 18

Current beta= 1.27 Current Equity= $5,673 Current Depreciation= $201

Current Debt= #VALUE! Current EBITDA= #VALUE! Current Interest rate (Company)= 5.00%
Tax rate= 27.40% Current Rating= AAA Current T.Bond rate= 4.65%

WORKSHEET FOR ESTIMATING RATINGS/INTEREST RATES

D/(D+E) 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% 90.00%
D/E 0.00% 11.11% 25.00% 42.86% 66.67% 100.00% 150.00% 233.33% 400.00% 900.00%
$ Debt $0 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Beta #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Cost of Equity #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!

EBITDA #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Depreciation $201 $201 $201 $201 $201 $201 $201 $201 $201 $201
EBIT #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Interest $0 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Taxable Income #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Tax #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Net Income #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
(+)Deprec'n $201 $201 $201 $201 $201 $201 $201 $201 $201 $201
Funds from Op. #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!

Pre-tax Int. cov ∞ #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Funds/Debt ∞ #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Likely Rating AAA #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Pre-tax cost of debt 5.90% #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Eff. Tax Rate 27.40% #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
COST OF CAPITAL CALCULATIONS
D/(D+E) 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% 90.00%
D/E 0.00% 11.11% 25.00% 42.86% 66.67% 100.00% 150.00% 233.33% 400.00% 900.00%
$ Debt $0 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Cost of equity #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Cost of debt 4.28% #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Cost of Capital #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Value (no growth) #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Value (perpetual growth)
#VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
 CAPITAL STRUCTURE 19

Interest cov Interest cov RATING Interest rate

Low High
-100000 0.2 D 24.65%
0.2 0.65 C 19.65%
0.65 0.8 CC 16.65%
0.8 1.25 CCC 14.65%
1.25 1.5 B- 13.15%
1.5 1.75 B 11.90%
1.75 2 B+ 10.65%
2 2.25 BB 9.65%
2.25 2.5 BB+ 8.90%
2.5 3 BBB 8.15%
3 4.25 A- 7.65%
4.25 5.5 A 7.15%
5.5 6.5 A+ 6.90%
6.5 8.5 AA 6.40%
8.5 100000 AAA 5.90%
 CAPITAL STRUCTURE 20

! I am ignoring working capital

e, I use the riskfree rate as a perpetual growth rate.

CAPITAL STRUCTURE 21
CAPITAL STRUCTURE 22
 Chart - Cost of Equity

Cost of Equity and Beta: Debt Ratios

12.00 12

10.00 10

8.00 8

6.00 6
Beta Cost of Equity

4.00 4

2.00 2

0.00 0
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Page 23
Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate
0% #VALUE! #VALUE! AAA 5.90% 27.40%
10% #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
20% #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
30% #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
40% #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
50% #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
60% #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
70% #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
80% #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
90% #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Cost of Debt (after-tax) WACC Firm Value (G)
4.28% #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!