Debt Policy and Value

EMBA 8500

#1
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 rd
Market value weights of:
Wd
Debt
We
Equity bL Levered beta
Rf
Risk-free Rate
Market Premium RM
Ke
Cost of equity
WACC
EBIT
- Taxes (34%)
EBIAT
+ Depreciation
- Capital expense
Change in Net Working Capital
Free Cash Flow
Value of Assets ( FCF/WACC)

CASE # 31

0% Debt
100% Equity
$
$
20,000
$
$
20,000
7.0%
4.62%

$
34% $
$
$
$
$
$

0
1
0.8
7%
8.6%
13.88%
13.88%
4,206.00
1,430.04
2,775.96
1,000.00
(1,000.00)
0
2,775.96
19,999.71

25% Debt
75% Equity
$
5,000
$
15,000
$
5,000
$
16,700
7.0%
4.62%

12/2/2012

50% Debt
1) As the firm becomes more leveraged the WACC will change because debtholders have a
50% Equity fixed claim on cash which increases the risk for stockholders. This can cause the stock to go up
$
10,000 and firms can reduce the taxes paid, thereby freeing up more cash. Debt also increases the risk
$
10,000 of bankruptcy.
$
10,000
$
13,400 (Debt * Tax Rate) + BV Equity
7.0%
4.62% (Pretax * (1-Tax Rate))

23.0%
42.7%
77.0%
57.3%
0.96
1.19
7%
7%
8.6%
8.6%
15.24%
17.27%
12.79%
11.86%
$
4,206.00 $
4,206.00
$
1,430.04 $
1,430.04
$
2,775.96 $
2,775.96
$
1,000.00 $
1,000.00
$ (1,000.00) $ (1,000.00)
0
0
$
2,775.96 $
2,775.96
$ 21,699.69 $ 23,399.66
Added Tax Shield increase value
VL = VU + TD

MV Debt / (MV Debt + MV Equity)
MV Equity / (MV Debt + MV Equity)
0.8 is the b u b L = b u [1+(1-T) * D/E
HAMADA

D/E Ratio
29.94%

74.63%

Ke = Rf + (b L * RM)
CAPM
WACC = (Wd * rd) + (We * re)
EBIT * Tax Rate
EBIT - Tax amount

V = FCF/WACC

M3DISK - Maryann Albert, Mike Arendosh, Mark Jarboe, Dan Pool, Ivo Hegelbach, Sean McPherson, Krista Massell

1