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FIN 560 – SPRING 2011

An Introduction to
Debt Policy and Value
Case 5
Toma Belizaire, Richard Frimpong, Uche Mba
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1. Many factors determine how much debt a firm takes on. Chief among them ought to be
the effect of the debt on the value of the firm. Does borrowing create value? If so, for
whom? If not, then why do so many executives concern themselves with leverage?
Borrowing creates value for shareholders, provided that the company borrows up to a
reasonable level. If a company borrows beyond a prudent level, value can be destroyed.

0% Debt/ 25% Debt/ 50% Debt/


100% Equity 75% Equity 50% Equity
Book Value of Debt $0 $2,500 $5,000
Book Value of Equity $10,000 $7,500 $5,000

Market Value of Debt $0 $2,500 $5,000


Market Value of Equity $10,000 $8,350 $6,700

Pretax Cost of Debt 5.0% 5.0% 5.0%

After-Tax Cost of Debt 3.3% 3.3% 3.3%

Market Value Weights of:


Debt 0 0.23   0.43
Equity 1.0 0.77   0.57
Levered Beta 0.00   0.9581   1.1940
Unlevered Beta 0.80 0.80 0.80
Risk-Free Rate 5.0% 5.0% 5.0%
Market Premium 6.0% 6.0% 6.0%
Cost of Equity 0.098   0.10749   0.12164
Weighted-Average Cost of Capital 0.098   0.09032   0.08376
EBIT $1,485 $1,485 $1,485
Taxes (@ 34%) $504.90   $504.90   $504.90
EBIAT $980.10   $980.10   $980.10
+ Depreciation $500 $500 $500
˗ Capital Exp. ($500) ($500) ($500)
Change in net working capital 0 0 0
Free Cash Flow $980.10   $980.10   $980.10
Value of Assets (FCF/WACC) $10,001.02   $10,851.11   $11,701.19

Why does the value of assets change? Where, specifically, do those changes occur?
The value of assets change because of the increase in debt. The changes occur where the market
value of debt increases.
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2. In finance, as in accounting, the two sides of the balance sheet must be equal. In the previous
problem, we valued the asset side of the balance sheet. To value the other side, we must
value the debt and the equity, and then add them together.

0% Debt/ 0% Debt/ 0% Debt/


100% Equity 75% Equity 50% Equity

Cash Flow to Creditors:


Interest $0 $125 $250
Pretax Cost of Debt 5.0% 5.0% 5.0%
Value of Debt:
(Interest/kd) $0 $2,500   $5,000

Cash Flow to Shareholders:


EBIT $1,485 $1,485 $1,485
Interest $0 ($125) ($250)
Pretax Profit   $1,485   $1,360   $1,235
Taxes (@ 34%)   $504.90   $462.40   $419.90
Net Income   $980.10   $897.60   $815.10
+ Depreciation $500 $500 $500
˗ Capital Exp. ($500) ($500) ($500)
+ Change in NWC $0 $0 $0
˗ Debt Amortiz. $0 $0 $0
Residual Cash Flow (RCF)   $980.10   $897.60   $815.10
Cost of Equity   0.098   0.10749   0.12164
Value of Equity (RCF/re)   $10,001.02   $8,350.93   $6,700.82
Value of Equity plus Value of Debt   $10,001.02   $10,850.93   $11,700.82

As the firm levers up, how does the increase in value get apportioned between creditors and
shareholders?
The reason for the increase in value is because of the debt from creditors. Therefore, creditors
get more of the increase in value apportioned to them than shareholders do.
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3. In the preceding problem, we divided the value of all the assets between two classes of
investors—creditors and shareholders. This process tells us where the change in value is
going, but it sheds little light on where the change is coming from. Let's divide the free cash
flows of the firm into pure business flows and cash flows resulting from financing effects.
Now, an axiom in finance is that you should discount cash flows at a rate consistent with the
risk of those cash flows. Pure business flows should be discounted at the unlevered cost of
equity (i.e., the cost of capital for the unlevered firm). Financing flows should be discounted
at the rate of return required by the providers of debt.

0% Debt/ 25% Debt/ 50% Debt/


100% Equity 75% Equity 50% Equity

Pure Business Cash Flows:


EBIT $1,485 $1,485 $1,485
Taxes (@ 34%) ($505) ($505) ($505)
EBIAT $980 $980 $980
+Depreciation $500 $500 $500
-Capital Exp. ($500) ($500) ($500)
+Change in NWC $0 $0 $0
Free Cash Flow (FCF) $980 $980 $980

Unlevered Beta 0.80 0.80 0.80


Risk-Free Rate 5.0% 5.0% 5.0%
Market Premium 6.0% 6.0% 6.0%
Cost of Equity 0.098 0.098 0.098
Unlevered WACC   0.098   0.098   0.098

Value of Pure Business Flows:


(FCF/Unlevered WACC)   $10,000.00   $10,000.00   $10,000.00

Financing Cash Flows:


Interest   0   $125.00   $250.00
Tax Reduction   0   $42.50   $85.00

Pretax Cost of Debt 5.0% 5.0% 5.0%

Value of Financing Effect:


(Tax Reduction/Pretax Cost of Debt)   $0.00   $850.00   $1,700.00

Total Value (Sum of Values of Pure


Business Flows and Financing Effects)   $10,000.00   $10,850.00   $11,700.00
The first three problems illustrate one of the most important theories in finance. The M&M
theory says:
Value of Value of
Value of Value of Value of
= + = Unlevered + Debt tax
assets debt equity
firm Shields
^ ^ ^
Problem 1 Problem 2 Problem 3
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4. What remains to be seen however, is whether shareholders are better or worse off with more
leverage. Problem 2 does not tell us, because there we computed total value of equity, and
shareholders care about value per share. Ordinarily, total value will be a good proxy for what
is happening to the price per share, but in the case of a relevering firm, that may not be true.
Implicitly we assumed that, as our firm in problems 1-3 levered up, it was repurchasing stock
on the open market (you will note that EBIT did not change, so management was clearly not
investing the proceeds from the loans in cash-generating assets). We held EBIT constant so
that we could see clearly the effect of financial changes without getting them mixed up in the
effects of investments. The point is that, as the firm borrows and repurchases shares, the
total value of equity may decline, but the price per share may rise.

Referring to the results of problem 2, let’s assume that all the new debt is equal to the cash
paid to repurchase shares.

Original market value of equity +Value of financing effect


Share price=
Number of original shares

0% Debt/ 25% Debt/ 50% Debt/


100% Equity 75% Equity 50% Equity

Total Market Value of Equity   $10,001.02   $8,350.93   $6,700.82


Cash Paid Out   $0   $2,500   $5,000
# Original Shares 1,000 1,000 1,000
Total Value Per Share   $10.00   $10.85   $11.70

5. In this set of problems, is leverage good for shareholders? Why? Is levering/unlevering


the firm something that shareholders can do for themselves? In what sense should
shareholders pay a premium for shares of levered companies?

In this case, leverage is good for shareholders at this point because it is increasing the value
of the company’s assets. Furthermore, leverage is good for shareholders because of the
potential of a higher return on investment, although there is a greater risk involved. Finally,
because of the increase in value that leverage brings, shareholders should pay a premium for
shares of levered companies.

6. From a macroeconomic point of view, is society better off if firms use more than zero
debt (up to some prudent limit)?

Society is better off because the use of more than zero debt up to some prudent level because
it allows banks to lend money. If banks do not lend money, they end up with excess cash
which leads to the fall of interest rates on bank deposits. Low interest rates eventually lead to
inflation which is not advantageous to the macroeconomic environment. Essentially, the
value of money will decrease.
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7. To test the valuation effects of the recapitalization alternative, assume that Koppers could
borrow a maximum of $1,738,095,000 at a pretax cost of debt of 10.5 percent and that the
aggregate amount of debt will remain constant in perpetuity. Thus, Koppers will take on
additional debt of $l,565,686,000 (I.e., $1,738,095,000 - $172,409,000). Also assume that
the proceeds of the loan would be paid as an extraordinary dividend to shareholders.

Before After
Recapitalization Recapitalization

Book Value Balance Sheets


Net working capital $212,453 $1,778,139.00 addt’l debt + NWC1
Fixed assets $601,446 $601,446.00
Total assets $813,899 $2,379,585.00

Long-term debt $172,409 $1,738,095.00 addt’l debt + LT debt1


Deferred taxes, etc. $195,616 $195,616.00
Preferred stock $15,000 $15,000.00
Common equity $430,874 $430,874
Total capital $813,899 $2,379,585.00

Market-Value Balance Sheets


Net working capital $212,453 $1,778,139.00
Fixed assets $1,618,081 $1,618,081.00
PV debt tax shield $58,619 $590,952.30 Tax Rate × LT debt2
Total assets $1,889,153 $3,987,172.00

Long term debt $172,409 $1,738,095


Deferred taxes, etc. $0 $0
Preferred stock $15,000 $15,000
Common equity $1,701,744 $2,234,077.30 CE1+Δ debt tax shield
Total capital $1,889,153 $3,987,172.30

Number of shares $28,128 $28,128


Price per share $60.50 $79.43 CE2/# of shares

Value to Public Shareholders


Cash received $0 $1,565,686
Value of shares $1,701,744 $668,391.30 CE2 ˗ Cash rec’d2
Total $1,701,744 $2,234,077.30
Total per share $60.50 $79.43

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