The cost of equity for Disney at different debt ratios can be computed using the unlevered

beta of the firm, and the debt equity ratio at each level of debt. We use the levered betas that

emerge to estimate the cost of equity. The first step in this process is to compute the firm™s

current unlevered beta, using the current market debt to equity ratio and a tax rate of 37.30%.

Unlevered Beta = Current Beta / (1 + (1-t) Debt/Equity)

= 1.2456/ (1 + (1-0.373) (14,668/55,101))

= 1.0674

Note that this is the bottom-up unlevered beta that we estimated for Disney in chapter 4,

based upon its business mix. We continued to use the treasury bond rate of 4% and the market

premium of 4.82% to compute the cost of equity at each level of debt. If we keep the tax rate

constant at 37.30%, we obtain the levered betas for Disney in table 8.2.

Table 8.2: Leverage, Betas And The Cost Of Equity

Debt Ratio D/E Ratio Levered Beta Cost of Equity

0.00% 0.00% 1.0674 9.15%

10.00% 11.11% 1.1418 9.50%

20.00% 25.00% 1.2348 9.95%

30.00% 42.86% 1.3543 10.53%

40.00% 66.67% 1.5136 11.30%

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50.00% 100.00% 1.7367 12.37%

60.00% 150.00% 2.0714 13.98%

70.00% 233.33% 2.6291 16.67%

80.00% 400.00% 3.7446 22.05%

90.00% 900.00% 7.0911 38.18%

In calculating the levered beta in this table, we assumed that all market risk is borne by

the equity investors; this may be unrealistic especially at higher levels of debt. We will

also consider an alternative estimate of levered betas that apportions some of the market

risk to the debt:

βlevered = βu [1+(1-t)D/E] - βdebt (1-t) D/E

The beta of debt is based upon the rating of the bond and is estimated by regressing past

returns on bonds in each rating class against returns on a market index. The levered betas

estimated using this approach will generally be lower than those estimated with the

conventional model.9

II. Disney's Cost of Debt and Leverage

Several financial ratios are correlated with bond ratings and, ideally, we could

build a sophisticated model to predict ratings. For purposes of this illustration, however,

we use a much simpler version: We assume that bond ratings are determined solely by

the interest coverage ratio, which is defined as:

Interest Coverage Ratio = Earnings before interest & taxes / Interest Expense

We chose the interest coverage ratio for three reasons. First, it is a ratio10 used by both

Standard and Poor's and Moody's to determine ratings. Second, there is significant

correlation not only between the interest coverage ratio and bond ratings, but also

between the interest coverage ratio and other ratios used in analysis, such as the debt

coverage ratio and the funds flow ratios. Third, the interest coverage ratio changes as a

firm changes is financing mix and decreases as the debt ratio increases. The ratings

9 Consider, for instance, a debt ratio of 40%. At this level the firm™s debt will take on some of the

characteristics of equity Assume that the beta of debt at a 0% debt ratio is 0.40. The equity beta at that debt

ratio can be computed as follows:

Levered beta = 1.0674 (1 + (1-.373)(40/60)- 0.40 (1-.373) (40/60) = 1.335

In the unadjusted approach, the levered beta would have been 1.5136.

10 S&P lists interest coverage ratio first among the nine ratios that it reports for different ratings classes on

its web site.

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agencies would argue, however, that subjective factors, such as the perceived quality of

management, are part of the ratings process. One way to build these factors into the

analysis would be to modify the ratings obtained from the financial ratio analysis across

the board to reflect the ratings agencies' subjective concerns11.

The data in table 8.3 were obtained based upon an analysis of the interest

coverage ratios of large manufacturing firms in different ratings classes.

Table 8.3: Bond Ratings and Interest Coverage Ratios

Interest Coverage Ratio Rating

> 8.5 AAA

6.50 - 6.50 AA

5.50 “ 6.50 A+

4.25 “ 5.50 A

3.00 “ 4.25 A-

2.50 “ 3.00 BBB

2.05 - 2.50 BB+

1.90 “ 2.00 BB

1.75 “ 1.90 B+

1.50 - 1.75 B

1.25 “ 1.50 B-

0.80 “ 1.25 CCC

0.65 “ 0.80 CC

0.20 “ 0.65 C

< 0.20 D

Source: Compustat

Using this table as a guideline, a firm with an interest coverage ratio of 1.65 would have a

rating of B for its bonds.

The relationship between bond ratings and interest rates in March 2004 was

obtained by looking at the typical default spreads12 for bonds in different ratings classes.

Table 8.4 summarizes the interest rates/rating relationship and reports the spread for these

11 For instance, assume that a firm's current rating is AA, but that its financial ratios would result in an A

rating. It can then be argued that the ratings agencies are, for subjective reasons, rating the company one

notch higher than the rating obtained from a purely financial analysis. The ratings obtained for each debt

level can then be increased by one notch across the board to reflect these subjective considerations.

12 These default spreads were estimated from bondsonline.com, a service that provides, among other data

on fixed income securities, updated default spreads for each ratings class.

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bonds over treasury bonds and the resulting interest rates, based upon the treasury bond

rate of 4%.

Table 8.4: Bond Ratings And Market Interest Rates, March 2004

Rating Typical default spread Market interest rate on debt

AAA 0.35% 4.35%

AA 0.50% 4.50%

A+ 0.70% 4.70%

A 0.85% 4.85%

A- 1.00% 5.00%

BBB 1.50% 5.50%

BB+ 2.00% 6.00%

BB 2.50% 6.50%

B+ 3.25% 7.25%

B 4.00% 8.00%

B- 6.00% 10.00%

CCC 8.00% 12.00%

CC 10.00% 14.00%

C 12.00% 16.00%

D 20.00% 24.00%

Source: bondsonline.com

Since Disney™s capacity to borrow is determined by its earnings power, we will begin by

looking at the company™s income statements in 2002 and 2003 in table 8.5. In 2003,

Disney had operating income of $2.713 billion and net income of $1,267 billion.

Table 8.5: Disney™s Income Statement for2002 & 2003

2003 2002

Revenues 27061 25329

- Operating expenses (other than depreciation) 23289 21924

EBITDA 3772 3405

- Depreciation and Amortization 1059 1021

EBIT 2713 2384

- Interest Expenses 666 708

+ Interest Income 127 255

Taxable Income 2174 1931

- Taxes 907 695

Net Income 1267 1236

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Based upon the earnings before interest and taxes (EBIT) of $2,713 million and

interest expenses of $ 666 million, Disney has an interest coverage ratio of 4.07 and

should command a rating of A-, a notch above it™s actual rating of BBB+. This income

statement, however, is based upon treating operating leases as operating expenses. In

chapter 4, we argued that operating leases should be considered part of debt and

computed the present value of Disney™s lease commitments to be $1,753 million.

Consequently, we have to adjust the EBIT and EBITDA for the imputed interest expense

on Disney™s operating leases13; this results in an increase of $ 92 million in both numbers

“ to $ 2,805 million in EBIT and $ 3,864 million in EBITDA.

Adjusted EBIT = EBIT + Pre-tax cost of debt * Present value of operating leases

= 2713 + .0525 * 1753 = 2805

Note that 5.25% is Disney™s current pre-tax cost of debt.

Finally, to compute Disney™s ratings at different debt levels, we redo the operating

income statement at each level of debt, compute the interest coverage ratio at that level of

debt and find the rating that corresponds to that level of debt. For example, table 8.6

estimates the interest expenses, interest coverage ratios and bond ratings for Disney at 0%

and 10% debt ratios, at the existing level of operating income.

Table 8.6: Effect of Moving to Higher Debt Ratios: Disney

D/(D+E) 0.00% 10.00%

D/E 0.00% 11.11%

$ Debt $0 $6,977

EBITDA $3,882 $3,882

Depreciation $1,077 $1,077

EBIT $2,805 $2,805

Interest $0 $303

Pre-tax Int. cov ∞ 9.24

Likely Rating AAA AAA

Pre-tax cost of debt 4.35% 4.35%

13Multiplying the pre-tax cost of debt by the present value of operating leases yields an approximation.

The full adjustment would require us to add back the entire operating lease expense and to subtract out the

depreciation on the leased asset.

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The dollar debt is computed to be 10% of the current value of the firm, which we

compute by adding the current market values of debt ($14,668) and equity ($55,101):

Dollar Debt at 10% debt ratio = .10 (55,101 + 14,668) = $ 6,977 million

Note that the EBITDA and EBIT remain fixed as the debt ratio changes. We ensure this

by using the proceeds from the debt to buy back stock. This is called a recapitalization,

where the assets of the firm remain unchanged but the financing mix is changed. This

allows us to isolate the effect of just changing the debt ratio.

There is circular reasoning involved in estimating the interest expense. The

interest rate is needed to calculate the interest coverage ratio, and the coverage ratio is

necessary to compute the interest rate. To get around the problem, we began our analysis

by assuming that you could borrow $ 6,977 billion at the AAA rate of 4.35%; we then

computed an interest expense and interest coverage ratio using that rate, and estimated a

new rating of AAA for Disney. This process is repeated for each level of debt from 10%

to 90%, and the after-tax costs of debt are obtained at each level of debt in Table 8.7.

Table 8.7: Disney: Cost of Debt and Debt Ratios

Interest

Debt Interest Coverage Bond Interest rate Tax Cost of Debt

Ratio Debt expense Ratio Rating on debt Rate (after-tax)

0% $0 $0 ∞ AAA 4.35% 37.30% 2.73%

10% $6,977 $303 9.24 AAA 4.35% 37.30% 2.73%

20% $13,954 $698 4.02 A- 5.00% 37.30% 3.14%

30% $20,931 $1,256 2.23 BB+ 6.00% 37.30% 3.76%

40% $27,908 $3,349 0.84 CCC 12.00% 31.24% 8.25%

50% $34,885 $5,582 0.50 C 16.00% 18.75% 13.00%

60% $41,861 $6,698 0.42 C 16.00% 15.62% 13.50%

70% $48,838 $7,814 0.36 C 16.00% 13.39% 13.86%

80% $55,815 $8,930 0.31 C 16.00% 11.72% 14.13%

90% $62,792 $10,047 0.28 C 16.00% 10.41% 14.33%

There are two points to make about this computation. We assume that at every

debt level, all existing debt will be refinanced at the new interest rate that will prevail

after the capital structure change. For instance, Disney's existing debt, which has a BBB+

rating, is assumed to be refinanced at the interest rate corresponding to a BBB rating

when Disney moves to a 30% debt ratio. This is done for two reasons. The first is that

existing debt-holders might have protective puts that enable them to put their bonds back

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to the firm and receive face value.14 The second is that the refinancing eliminates “wealth

expropriation” effects ““ the effects of stockholders expropriating wealth from

bondholders when debt is increased, and vice versa, when debt is reduced. If firms can

retain old debt at lower rates, while borrowing more and becoming riskier, the lenders of

the old debt will lose wealth. If we lock in current rates on existing bonds and recalculate

the optimal debt ratio, we will allow for this wealth transfer.15

While it is conventional to leave the marginal tax rate unchanged as the debt ratio

is increased, we adjust the tax rate to reflect the potential loss of the tax benefits of debt

at higher debt ratios, where the interest expenses exceed the earnings before interest and

taxes. To illustrate this point, note that the earnings before interest and taxes at Disney is

$2,805 million. As long as interest expenses are less than $ 2,703 million, interest

expenses remain fully tax deductible and earn the 37.30% tax benefit. For instance, at a

40% debt ratio, the interest expenses are $1,865 million and the tax benefit is therefore

37.30% of this amount. At a 50% debt ratio, however, the interest expenses balloon to

$3,349 million, which is greater than the earnings before interest and taxes of $ 2,805

million. We consider the tax benefit on the interest expenses up to this amount:

Maximum Tax Benefit = EBIT * Marginal Tax Rate = $2,805 million * .373 = $

1,046 million

As a proportion of the total interest expenses, the tax benefit is now only 31.24%:

Adjusted Marginal Tax Rate = Maximum Tax Benefit / Interest Expenses =

$1046/$3,349= 31.24%

This, in turn, raises the after-tax cost of debt. This is a conservative approach, since

losses can be carried forward. Given that this is a permanent shift in leverage, it does

make sense to be conservative.

III. Leverage and Cost of Capital

Now that we have estimated the cost of equity and the cost of debt at each debt

level, we can compute Disney™s cost of capital. This is done for each debt level in Table

14 If they do not have protective puts, it is in the best interests of the stockholders not to refinance the debt