AN INTRODUCTION TO DEBT POLICY AND VALUE

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? If leverage affects value, then it should cause changes in either the discount rate of the firm (i.e., its weighted-average cost of capital) or the cash flows of the firm. 1. Please fill in the following: 0% Debt/ 100% Equity $$10,000 $$10,000 7.00% 4.62% 25% Debt/ 75% Equity $2,500 $7,500 $2,500 $8,350 7.00% 4.62%

Book Value of Debt Book Value of Equity Market Value of Debt Market Value of Equity Pretax Cost of Debt After-Tax Cost of Debt Market Value Weights of Debt Equity Unlevered Beta Levered Beta Risk-Free Rate Market Premium Cost of Equity Weighted-Average Cost of Capital EBIT Taxes (@ 34%) EBIAT + Depreciation Capital Exp. Free Cash Flow

0% 100% 0.800 0.800 7.00% 8.60% 0.00% $2,103.00

0.800 7.00% 8.60% 0.00% $2,103.00

$500.00 $(500.00)

$500.00 $(500.00)

Value of Assets (FCF/WACC) Why does the value of assets change? Where, specifically, do the changes occur?

50% Debt/ 50% Equity $5,000 $5,000 $5,000 $6,700 7.00% 4.62%

0.800 7.00% 8.60% 0.00% $2,103.00

$500.00 $(500.00)

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/ 100% Equity

25% Debt/ 75% Equity

Cash Flow to Creditors: (interest) Pretax Cost of Debt Value of Debt: (CF/rd) Cash Flow to Shareholders: EBIT Interest Pretax Profit Taxes (@ 34%) Net Income + Depreciation Capital Exp. Debt Amortiz. Residual Cash Flow Cost of Equity

$0.07

$175.00 0.07

$2,103.00 $-

$2,103.00 $(175.00)

$500.00 $(500.00) $-

$500.00 $(500.00) $-

Value of Equity (CF/re) Value of Equity plus Value of Debt

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

50% Debt/ 50% Equity

$350.00 0.07

$2,103.00 $(350.00)

$500.00 $(500.00) $-

3. In the preceding problem, we divided the value of all the assets between two classes of investorscreditors 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/ 100% Equity Pure Business Cash Flows: EBIT Taxes (@ 34%) EBIAT +Depreciation Capital Exp. Cash Flow Unlevered Beta Risk-Free Rate Market Premium Unlevered WACC Value of Pure Business Flows: (CF/Unlevered WACC) Financing Cash Flows Interest Tax Reduction Pretax Cost of Debt Value of Financing Effect: (Tax Reduction/Pretax Cost of Debt) Total Value (Sum of Values of Pure Business Flows and Financing Effects) 0.07

25% Debt/ 75% Equity

$2,103.00 $715.02 $1,387.98 $500.00 $(500.00) $1,387.98 0.800 7.000% 8.600%

$2,103.00 $715.02 $1,387.98 $500.00 $(500.00) $1,387.98 0.800 7.000% 8.600%

0.07

The first three problems illustrate one of the most important theories in finance. This theory, developed by two professors, Franco Modigliani and Merton Miller, revolutionized the way we think about capital-structure policies. The M&M theory says, Value of Assets = Value of + Equity Value of Value of Value of = Unlevered + Debt Tax

Debt

Firm ^ Problem 1 ^ ^ Problem 2

Shields

Problem 3

50% Debt/ 50% Equity

$2,103.00 $715.02 $1,387.98 $500.00 $(500.00) $1,387.98 0.800 7.000% 8.600%

0.07

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. Now, solving for the price per share may seem impossible, because we are dealing with two unknownsshare price and change in the number of shares: Share Total Market Price = Value of Equity (Original - Repurchased Shares Shares)

But by rewriting the equation, we can put it in a form that can be solved:

Share Total Market Cash Price = Value of Equity + Paid Out # Original Shares

Referring to the results of problem 2, let's assume that all the new debt is equal to the cash paid to repurchase shares. Please complete the following table:

0% Debt/ 100% Equity Total Market Value of Equity Cash Paid Out # Original Shares Total Value Per Share

25% Debt/ 75% Equity

1000

1000

50% Debt/ 50% Equity

1000