Coporate Finance Case Study

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Case Study corporate finance
Case 28 – An Introduction to Debt Policy and Value
Case 30 – MCI Communications, Corp.: Capital Structure Theory


Table of Contents

Case 28 - An Introduction to Debt Policy and Value3
Effects of Debt on the Value of the Firm3
Split of Value between Creditors and Shareholders4
Source of Value Creation4
Effects on Value per Share5
The Benefits of Leveraging for the Shareholders6
The Macroeconomic Benefit of Debts7
Koppers Company, Inc.7
Case 30 – MCI Communications, Corp.: Capital Structure Theory9 Introduction9
Cost of Capital9
Costs of Equity9
Cost of Debt10
Scenario Analysis11
Leverage and Risk – Coverage Ratio11
Leverage and Earnings – Earnings per Share12
The Creditor’s Reaction14
Impact on Financial Flexibility15
Summary and Concluding Remarks16

Case 28 - An Introduction to Debt Policy and Value
The following case is about the management of the corporate capital structure. In this context, we deal particularly with the questions on debt policy and value. Effects of Debt on the Value of the Firm

Borrowing for itself does not create any value. However, borrowing might influence the capital structure of a firm in a way that changes the weighted average costs of capital (WACC) which consequently has effects to the value of the firm, too. However, in reality whether this statement is true or wrong is not only depended on various individual circumstances (e.g. tax rate, risk factors, financial market access, types of assets, etc.) but is also subject to controversial discussions among both theorist and practitioners. Financial theorists argue that in a world with no bankruptcy costs but with corporate taxes, the firm value is an increasing function of leverage (Ross, Westerfield and Jaffe, 2002, p. 416). This finding implies that a firm should borrow as much as possible in order to increase its value. In reality, firms finance their operation more conservative, particularly in order to reduce their risk of financial distress. So who benefits from borrowing? There is no clear answer either. On the one hand, one could argue that financial leverage may benefit stockholders in case the return on the capital borrowed is larger than the related costs. Existing bondholders may loose in this case as they face only a higher default risk without getting any additional compensation for it. On the other hand, stockholders are more related to the costs of financial distress in case of bankruptcy compared to bondholders as they have usually an earlier claim on the firm’s asset. Looking at the tables below, we further discuss the roles of debt and equity in the capital structure of a firm.

As it can be noticed in above table, the cash flow of the firm remains unchanged whereas the discount rate (measured as the WACC) is reduced. According to financial market theory, this reduction should lead to an increase in firm value. More specifically, the value of the assets changes because the required rate of return decreases. Those changes occur on the passive side of the firm’s balance sheet. In simple terms, the firm adjusts its capital structure to maximize the overall value of the firm. Split of Value between Creditors and Shareholders

So how is the increased value spread between creditors and stockholders? To answer the question, let us first have a look at table 2.

As it is shown, the total value of the firm increases as leverage goes up. The increasing costs of equity are more than compensated by the positive effects of financial leverage. To answer the question regarding the split of the increased value between creditors and stockholders the answer seems to be quite obvious: the stockholders benefit most. However, it should be kept in mind that this...
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