An Introduction to Debt Policy and Value

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% equity 25%debt/75% equity 50%debt/50% equity
BV of debt 0 $2,500 $5,000
BV of equity $10,000 $7,500 $5,000
MV of debt 0 $2,500 $5,000
MV of equity $10,000 $8,350 $6,700
Pretax cost of debt 0.07 0.07 0.07
After-tax cost of debt 0.0462 0.0462 0.0462
Market Weight of Debt 0 0.23 0.43
Market Weight of Equity 1.0 0.77 0.57
Un-levered Beta 0.8 0.8 0.8
Risk free rate 0.07 0.07 0.07
Market premium 0.086 0.086 0.086
Cost of equity 13.88% 15.4% 20.8%
WACC 13.88% 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)
FCF 1,388 1,388 1,388
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