Sensitivity Analysis

The optimal debt ratio we estimate for a firm is a function of all the inputs that go into the cost of capital computation - the beta of the firm, the riskfree rate, the risk premium and the default spread. It is also, indirectly, a function of the firm's operating income, since interest coverage ratios are based upon this income, and these ratios are used to compute ratings and interest rates.

The determinants of the optimal debt ratio for a firm can be divided into variables specific to the firm, and macro economic variables. Among the variables specific to the firm that affect its optimal debt ratio are the tax rate, the firm's capacity to generate operating income and its cash flows. In general, the tax benefits from debt increase as the tax rate goes up. In relative terms, firms with higher tax rates will have higher optimal debt ratios than will firms with lower tax rates, other things being equal. It also follows that a firm's optimal debt ratio will increase as its tax rate increases. Firms that generate higher operating income and cash flows, as a percent of firm market value, also can sustain much more debt as a proportion of the market value of the firm, since debt payments can be met much more easily from prevailing cash flows.

The macroeconomic determinants of optimal debt ratios include the level of interest rates and default spreads. As interest rates increase, the costs of debt and equity both increase. However, optimal debt ratios tend to be lower when interest rates are higher, perhaps because interest coverage ratios drop at higher rates. The default spreads commanded by different ratings classes tend to increase during recessions and decrease during recoveries. Keeping other things constant, as the spreads increase, optimal debt ratios decrease, for the simple reason that higher default spreads result in higher costs of debt.

How does sensitivity analysis allow a firm to choose an optimal debt ratio? After computing the optimal debt ratio with existing inputs, firms may put it to the test by changing both firm-specific inputs (such as operating income) and macro-economic inputs (such as default spreads). The debt ratio the firm chooses as its optimal then reflects the volatility of the underlying variables, and the risk aversion of the firm's management.

Illustration 8.4: Sensitivity Analysis on Disney's Optimal Debt Ratio

In the base case, in illustration 8.2, we used Disney's operating income in 2003 to find the optimal debt ratio. We could argue that Disney's operating income is subject to large swings, depending upon the vagaries of the economy and the fortunes of the entertainment business, as shown in Table 8.11.

Table 8.11: Disney's Operating Income History: 1987 - 2003

Year

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