Optimal Cost of Capital: ExxonMobil 3
I am searching for the Optimal Cost of Capital for ExxonMobil. Therefore I need:
1/ The optimal debt ratio --> is the industry debt ratio the optimal ratio ? why ? I would say that the optimal debt ratio is the one optimising the cost of capital
2/ Once you have a debt ratio target, you need to adapt your Ke and Kd. Ke is done through Beta L. My issue is with adapting Kd. The firm is AAA, and interest coverage is more than 500... by simulating the coverage it is always bigger than 8, then it will remain a AAA.
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Then my Kd is constant, whatever the debt ratio.
Conclusion is: because Kd (5%) is lower than Ke (6%) in any debt ratio, the debt ratio should be 100% and the cost of capital should be Kd.
How can I improve this ?
is there any other way to simulate Kd in function of the debt ratio than the interest coverage ?
The cost of equity will also be affected by your financing decision since your choice to raise debt will increase your debt/equity ratio,thus increasing your levered beta,cost of equity and cost of capital.
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Fsbatista1: thank you. For the Ke I have no issue, my issue is more on the Kd (debt rate)
Nobody knows ?
in the limiting case, if the firm is 100% debt financed, the cost of debt has to, by definition, equal the cost of equity for the unlevered firm. (This is in a tax-free world)
The assets of the firm are unaffected by the capitalization structure, so ROA is constant. (Tax free or after tax world)
What I think you have wrong is how you are looking at the D/(D+E) ratio.
You are likely using book value of debt (ok) and book value of equity (not ok). To finance exxonmobile 100% debt, you would have to buy back ALL the stock at the current stock market price per share. The "E" in the D/(D+E) ratio should be the market value of equity, NOT the book value of equity.
If you issued that much debt, I cannot believe that the firm would maintain its AAA rating. Ratings are based on more than just a single coverage ratio, they also consider the D/(D+E)
Finally, it is customary to include a cost of financial distress in your "optimal" capitalization structure exercise. At 100% debt, the costs of financial distress would be quite high, and likely overwhelm the marginal benefit of tax savings on debt.
Hope this helps.
Thanks Lyam for your message.
I agree on everything your wrote. Than my question is: how then can I evaluate Kd ? Now the debt ratio is 8%. If I want to simulate Kd for a debt ratio of 20%, what is the right approach then ?
Aswath ? Any idea ?
I think one of the ways out may be to see if there is a peer company with a debt ratio close to 20%.
Thanks for your answer. Many ways to find "something", still not 100% sure if it is the right way.
Thank you to all for your feedback !
Here is the flaw in your logic. You are keeping the cost of debt fixed while you compute the interest expenses. In reality, you should be building in an iterative process which will cause the interest rate to rise as the debt rises. It is true, though, that Exxon has a high optimal. My last computation a few months ago gave me a 70% optimal debt ratio.
Thank you very much for anwering! Interesting idea this iterative process. I will try it!
By the way, would it be possible for you to share your last computation from few month ago ? If not publicly, I can give my email address.