An Introduction to Debt Policy and Value

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FIN 450

Rami Ahmed Al Hasan @16253
Elias Elkoussa @17067
May Mohammed @14325
Deena Shalab@16457
Reem Hani Arab @16185

CASE 4
An Introduction to Debt Policy and Value

1
(Table format and content from case)
0% debt/100% equity25%debt/75% equity50%debt/50% equity
BV of debt0$2,500$5,000
BV of equity$10,000$7,500$5,000
MV of debt0$2,500$5,000
MV of equity$10,000$8,350$6,700
Pretax cost of debt0.070.070.07
After-tax cost of debt0.04620.04620.0462
Market Weight of Debt00.230.43
Market Weight of Equity1.00.770.57
Un-levered Beta0.80.80.8
Risk free rate0.070.070.07
Market premium0.0860.0860.086
Cost of equity13.88%15.4%20.8%
WACC13.88%13.5%13.8%
EBIT$2,103$2,103$2,103
- Taxes - 34%$1,388$1,388$1,388
EBIAT$1,388$1,388$1,388
+ Depreciation$500$500$500
- Cap exp.$(500)$(500)$(500)
FCF1,3881,3881,388
Value of assets$10,000$10,281$10,058

The following are calculations for:

0% debt:

Cost of equity = Rf + Bu (Km - Krf) = 0.07 + 0.8(0.086) = 13.88% WACC = WD*Kd+ Ws*rs = 0 + 13.88 = 13.88%
NOTE THAT: Km - Krf = Market Risk Premium

25% debt

Rs = r0 + D/E(r0-rb) = 13.88 + 1/3(13.88- 7) = 16.1

Alternatively:

Bl = Bu {1+ (1-T) (D/E)} = .8{1+ (1- .34) (1/3) = .976
Cost of equity = Rf+ Bl (Km - Krf) = 0.07+ .976 (0.086) = 15.4% WAAC = .23*0.0462+ .77* 0.161= 13.5%
NOTE THAT: Km - Krf = Market Risk Premium

50% debt

Rs = r0 + D/E(r0-rb) = 13.88 + 1(13.88- 7) = 20.8%

WACC = .43*0.0462+ .57*.208= 13.8%

Above we see that more debt has increases the value of assets for the firm but that was only true at the 25 % debt level where the increases debt level lowered the beta for assets. As more debt was added (50%), the beta for assets rose, causing the WACC to rise again and reduce the value of the assets that are discounted at WACC. The optimal point may lie somewhere between the 25 and 50% at the point where WACC is at its lowest. However it is difficult to reach the optimum since risk factors and debt levels change over time.

2

(Table format and content from case)
0% debt25% debt50% debt
Cash flow to creditors:
Interest0$175$350
Pre- tax cost of debt0.070.070.07
Value of debt: CF/rd0$2,500$5,000
Cash flow to shareholders:
EBIT$2,103$2,103$2,103
- interest0$(175)$(350)
Pretax profit$2,103$1,928$1,753
Taxes - 34%$715$655.5$596
Net income$1,388$1,272.5$1,157
+ depreciation$500$500$500
- Cap Exp$(500)$(500)$(500)
- debt amortization000
Residual cash flow$1,388$1,272.5$1,157
Cost of equity13.88%15.4%20.8%
Value of equity: CF/re$10,000$8,263$5,562.5
Value of firm = value of debt + value of equity0+10,000
= $10,000$2,500+ 8,263
= $10,763$5,000+ 5,562.5
$10.562.5

As the level of debt rises, a grater portion of the firm is debt value and thus a greater share of cash flow , mainly in terms of interest, goes to bondholders and creditors. More debt simply means that the value of the firm is split up more in favor of creditors than stock holders and it is reflected in the lower value of equity. However, it is just a matter of division of value but over all the value of the firm has risen with debt making it beneficial to both equity holders and creditors. Yet it is interesting to not that beyond the optimal debt point (when asset values start decreasing as more debt is added) the value of equity starts falling but the value of debt still increases.

3

(Table format and content from case)
0% debt25% debt50% debt
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
Un-levered beta0.80.80.8
rf0.070.070.07
Market premium0.0860.0860.086
Un-levered WACC13.88%13.88%13.88%
Value of pure business flows:
CF/WACC un-levered.$10,000$10,000$10,000
Financing cash flows...
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