Aa

Pre-tax cost of debt

4.35%

4.50%

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 AA for Disney. We recomputed the interest expense using the AA rate14 of 4.50% as our cost of debt. 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.

13 Multiplying 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.

Table 8.7: Disney: Cost of Debt and Debt Ratios
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