MBA 505 Tabish Syed

Financial Management b00015165

CASE STUDY
AN INTRODUCTION TO DEBT POLICY AND VALUE

1) Does borrowing create value? If so, for whom? If not, then why do so many executives concern
themselves with leverage?

Yes, borrowing creates value for the shareholders because right amount of debt financing will:-
a) Reduce the taxes paid
b) Free up more cash for payments to investors
c) Reduce after-tax cost of debt

But, the value will be created if the firm borrows to a certain level i.e. the right amount of debt and
equity. If too much debt is taken then the value will be destroyed.

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

100% Equity 75% Equity 50% Equity

Book Value of Debt $0 $2500 $5000

Book Value of Equity $10000 $7500 $5000

Market Value of Debt $0 $2500 $5000

Market Value of Equity $10000 $8350 $6700

Pretax Cost of Debt 7.00% 7.00% 7.00%

After-Tax Cost of Debt 4.62% 4.62% 4.62%

Market Value Weights of

Debt 0% 23% 43%
Equity 100% 77% 57%
Unlevered Beta 0.80 0.80 0.80
Levered Beta(1) 0.80 0.96 1.19
Risk-Free Rate 7.0% 7.0% 7.0%
Market Premium 8.6% 8.6% 8.6%
Cost of Equity 13.88% 15.24% 17.27%
Weighted-Average Cost of Capital(2) 13.88% 12.79% 11.86%
EBIT $2,103 $2,103 $2,103
Taxes (@ 34%) ($715) ($715) ($715)
EBIAT $1,388 $1,388 $1,388
+ Depreciation $500 $500 $500
Capital Exp. ($500) ($500) ($500)
Free Cash Flow $1,388 $1,388 $1,388
Value of Assets (FCF/WACC)(3) $10,000 $10,850 $11,700

Notes:

Levered Beta is calculated using the market weights of Debt and Equity.

rd is the pretax cost of debt

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MBA 505 Tabish Syed
Financial Management b00015165

Assuming there is no growth

Why does the value of assets change? Where, specifically, do those changes occur?

The value of assets changes because of the increase in debt i.e. borrowing instead of equity. The
changes occur where the market value of debt increases.
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/ 25% Debt/ 50% Debt/

100% Equity 75% Equity 50% Equity

Cash Flow to Creditors:

Interest 0 175 350
Pretax Cost of Debt 0.07 0.07 0.07
Value of Debt
(CF/rd) $0 $2,500 $5,000

Cash Flow to Shareholders:

EBIT $2,103 $2,103 $2,103
Interest $0 $175 $350
Pretax Profit $2,103 $1,928 $1,753
Taxes (@ 34%) ($715) ($656) ($596)
Net Income $1,388 $1,272 $1,157
+ Depreciation 500 500 500
Capital Exp. -500 -500 -500
Debt Amortiz. 0 0 0
Residual Cash Flow $1,388 $1,272 $1,157

Cost of Equity 13.88% 15.24% 17.27%

Value of Equity (CF/re) $10,000 $8,350 $6,700

Value of Equity plus Value of Debt $10,000 $10,850 $11,700

As the firm levers up, how does the increase in value get apportioned between creditors and
shareholders?

As the firm levers up the value gets distributed among the creditors and the 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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MBA 505 Tabish Syed
Financial Management b00015165

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 $2,103 $2,103 $2,103
Taxes (@ 34%) ($715) ($715) ($715)
EBIAT $1,388 $1,388 $1,388
+Depreciation $500 $500 $500
Capital Exp. ($500) ($500) ($500)
Cash Flow $1,388 $1,388 $1,388

Unlevered Beta 0.8 0.8 0.8

Risk-Free Rate 7.0% 7.0% 7.0%
Market Premium 8.6% 8.6% 8.6%
Cost of Equity 13.88% 13.88% 13.88%
Unlevered WACC 13.88% 13.88% 13.88%

Value of Pure Business Flows:

(CF/Unlevered WACC) $10,000 $10,000 $10,000

Financing Cash Flows

Interest $0 $175 $350
Tax Reduction $0 $60 $119

Pretax Cost of Debt 7.0% 7.0% 7.0%

Value of Financing Effect: $0 $850 $1,700

(Tax Reduction/Pretax Cost of Debt)

Total Value (Sum of Values of

Pure Business Flows and $10,000 $10,850 $11,700
Financing Effects)

The first three problems illustrate one of the most important theories in finance. The M&M theory says:

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MBA 505 Tabish Syed
Financial Management b00015165

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.

Total market value of equity +Cash Paid Out

Share price=
Number of original shares

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

100% Equity 75% Equity 50% Equity

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

Cash Paid Out $0 $2,500 $500
# Original Shares 1000 1000 1000
Total Value Per Share $10 $11 $7

5) 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 because it is increasing the value of the company,
decreasing the cost of capital of the firm and increasing the share price. Also, due to the leverage the
firm is saving on tax due to payments in interest i.e. leverage is acting as tax shield. The shareholders can
themselves do the levering / unlevering of the firm by buying bonds of that firm and selling the equity.
By doing this, the firm is being levered as it is borrowing money from the shareholders. Furthermore,
leverage is good for shareholders because of the potential of a higher return on investment, but there is
a greater risk involved. As debt increases the chances of bankruptcy also increases. Finally, because of
the increase in value that leverage brings, shareholders should pay a premium for shares of levered
companies.

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MBA 505 Tabish Syed
Financial Management b00015165
6) From a macroeconomic point of view, is society better off if firms use more than zero debt (up to
some prudent limit)?

Yes, 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.
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
$1,565,686,000 (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.

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