An Introduction to Debt Policy and Value

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Question 1: Does Borrowing Create Value? If so, for whom? If not, then why do so many executives concern themselves with leverage? It depends; Borrowing creates value if the company borrows at the optimal amount of debt or less. If the company borrows more than the optimal amount of debt, then borrowing will destroy value. Borrowing will increase value of the firm through the tax shield that borrowing brings. Thus, the increase value of the firm will increase the value of equity and create value to shareholders. {draw:frame} {draw:frame} *If leverage affects value, then s*hould* it* cause changes in either the discount rate of the firm (i.e., it’s WACC) or the cash flows of the firm. Leverage affects value through the change in WACC not in the cash flows of the firm. WACC = (Wd (1-t) Kd) + (We * Ke). With change in leverage, Wd will change, which in return will change the WACC. Why does the value of assets change? Where, specifically, do the changes occur? The value of assets change due to the change in WACC. Question 2: {draw:frame} {draw:frame} *As the firm levers up, how does the increase in value get apportioned between creditors and shareholders*? the increase in value gets apportioned based on the market value weights of Debt and Equity. For example, with 25% Debt and 75% Equity The market value weight of Debt =23% The market value weight of Equity = 77% Value of Debt / Value of Debt +Equity = 2500 / 10849.87 = 23% Value of Equity/ Value of Debt + Equity = 8349.87 / 10849.87 = 77% Question 3: {draw:frame} {draw:frame} Question 4: {draw:frame} {draw:frame} Question 5: Is leverage good for shareholders? Why? Is levering/unlevering the firm something shareholders can do for themselves? In what sense should shareholders pay a premium for levered companies? Yes, because it decreases WACC since the cost of debt decreases because of taxes. Since WACC decreases, the value of assets increases....
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