A Case Study

You have the opportunity to visit SAP AG, the business software company. Based in Walldorf, Germany, SAP offers software development and implementation in application areas such as accounting, logistics and human-resource management to large businesses in Europe, North America and around the world. In 2000 the company had sales of over EUR6.2 billion.

In recent months the company's stock price has been depressed, and management is concerned about re-examining the financial structure. Management is also concerned with the financing of forthcoming acquisitions: should SAP continue to take advantage of its strong cash flow, or should it begin to use debt financing? If it does raise additional debt, the proceeds will be used for a stock buyback.

You have been asked to evaluate whether the company has an appropriate amount of debt. You have collected the following information about SAP's current position:
Current share price:  117 EUR
Shares outstanding:   316   million
Beta of the stock based on the German DAX index:    1.3
Debt outstanding:   200   EUR million
Debt rating:  AAA
Market rate on bonds with rating   AAA 5.65%
Government 10-year bond rate:   4.80%
DAX long-run expected return   9.80% or 5.00% over governments
Company's marginal tax rate:   38%
2001 estimated pretax profit   1568
2001 est. book value of equity   3734
Based on the company's business, its interest coverage and other factors, you have prepared a table
showing what an increase in long term debt would do to the company's ratings and its cost of borrowing
as well as several key ratios:
Additional debt  New Rating Interest rate Interest expense  Interest coverage ratio  Debt/capitalization  Debt/book equity
0 AAA 5.65% 11 138.76 1% 0.1
2500 AAA 5.65%  153  10.28  7%  0.7
5000 A 6.37%  331  4.73  14%  1.4
7500 A- 6.56%  505  3.10  21%  2.1
10000 B+ 10.90%  1,112  1.41  27%  2.7 

1. Should SAP take on additional debt? If so, how much?
2. What is the weighted average cost of capital before and after the additional debt?
3. How much does SAP's value increase as a result of the lower cost of capital? What will be the estimated price per share after the company takes on new debt?

(Hint: we can assume that the additional value comes from the savings from a lower cost of capital each year, and that the savings will continue indefinitely.)

Exhibit 1: Summary SAP Financials
Exhibit 2: Corporate Bond Spreads
Exhibit 3: Cost of Capital Calculation

Suggested solution:

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