31 An Introduction to Debt Policy and Value Many factors determine how much debt a firm takes on. Chief among them ought to be the effect of the debt on the value of the firm. Does borrowing create value? It so for whom? If not, then why do so many executives concetn themselves with lever If leverage affects value, then it should cause changes in either the discount rate fof the firm (that is its weighted-average cost of capital) or the cash flows of the firm, 1. Please fill in the following: 0% Debi 25% Deby 60% Debi 100% Equity 75% Equity Book Value of Debt Book Valve of Equity 10,000 Market Value of Debt = $2,500 Market Value of Equity $10,000 98,350 Pretax Cost of Debt 5.00% Atter-Tax Cost of Debt Market Value Weights of Deb Equity Levered Beta Risk Free Rate Market Premium Equty draverage Cost of Capital Taxes (@ 34%) (Continued) This ws prepae by Robe Frnt was weiten a ass orcas cussion ater han to lust fective or ineectve handling ofan anise situation, Copyright © 1989 be the Ua enity Virginia Darden School Foundation, Chalatesile, VA. All abt reserved to sales@drdenbusinesspublisng com. No prt of i(Continued) O% Deby «25% Deby «50% Debt c To0% Equity 75% Equity 50% Equin EBIAT ans - Depreciation $500 3500 Capital exo. ($500 ($500) ‘Change in net working capital = = = Free Cash Flow Val of Assets (FCFIWACC) Why does the value of assets change? Where, specifically, do those ch In finance, as in accounting, the two sides of the balance sheet must be equal the previous problem, we valued the asset side of the balance sheet, To value other side, we must value the debt and the equity, and then ndd them togethe 0% Debt 25% Deby 0% Dobe De 100% Equity 75% Equity —_S0% Equa c Cash flow to creditors Interest 3125 Fee Pretax cost of dobt 5.0% 5.0% Unlove Value of deb (nuk) = Cash flow to shareholders: eBrr 81.405 31.405 Valve Interest $125 (FF Uri Pretax prot = sili Taxes (@ 34%) = a Net income Oe ne Depreciation 500 $500 $s Captal ($500) ($500) Pretax CChange in nat werkng capital = = 4 Vaso Deot amortization 2 — - Fesidual cash flow Cost of equity = Value of equity (RFK) Value of equity plus value of debt As the firm levers up, how does the increase in value get apportione the creditors and the shareholders?1n the preceding problem, we divided the value of all the assets between two classes of investors: creditors and sharcholders. Ths process tells us where che n Value is going, but it sheds litle light on where the change is coming from. Let's divide the fee cashflows othe fim into mee ec flows and cash ows resulting from financing effects. Now, an axiom in finance is that you shalt tiscount cashflows a arate consistent with the risk of those cash flows Pare business flows should be discounted atthe unlevered cost of equity (ie, the cost Sr Capital forthe unlevered firm). Financing flows should be discounted atthe exe cof retum requited by the providers of debt 0% Debi? 25% Debt) 50% Debi Equity 75% Equity sox Equity Pure Busine EIT St.405 s1.405 Taxes (@ 24%) $505 $505 EBIAT $980 sso80 Deprociation $500 $500 Capial exp. ($500) (ss00) Change in net working capital S| Free Cash Flow $980 980 Unievered Bota os oe Risk-Free Rate 50% 5.0% Market Premium 60%. Unlevored Wace. Value of Pure Business Flows: (FoF/Unievered wacc) Financing Cash Flows Tax Reduction Protax Gost of Debt Value of Financing Efect, (Tax Reductor’Pretax Cost of Debi) Total Value (Sum of Values of Pure Business Flows and Financing The first three problems illustrate one of the most important theories in finance. This theory, developed by two professors, Franco Modigliani and Merton Mille, revolutionized the way we think about eapital structure policies,The M&M theory says: Value of Value of Value of | Value of Value of assets = debt + equity = unlevered + debt tax firm shields Problem | Problem 2 Problem 3 4. What remains to be seen, however, is whether shareholders are better or wor with more leverage. Problem 2 does not tell us because there we computed value of equity, and shareholders care about value per share. Ordinarily Will be a good proxy for what is happening to the price per share, but in the 1 relevering firm, that may not be rue, Implicitly, we assumed that, as our fins problems 13 levered up, it was repurchasing stock on the open market (yo hhote that EBIT did not change, so management was clearly not investing the Js from the loans into cash-generating assets). We held EBIT constant so Sat we could see clearly the effect of financial chang in the effects of investments. The point is that, as the firm borrows and repurcis shares the total value of equity may decline, but the price per share may ris .es without getting them i Now, solving for the price per share may seem impossible because we dealing with two unknowns—share price and the change in the number of & Market value of equity ve Price ~ Gyiginal shares — Repurchased shares But by rewriting the equation, we can put it in a form that can be solved s Original market value of equity + Value of financing effec hare price ‘Number of original shares Referring to the results of problem 2, let's assume that all the new e the follow equal to the eash paid to repurchase shares, Please comple 0% Debt 25% Debt 100% Equity 75% Equity 50% Equmy Total Market Value of Equty — cash Paid Out ee # Original Shares 000 1,000 10 Total Value Per Share —____— "Debs iae shields canbe valued by discounting the fate annual tax savings a the pretax co Fr debt that iy assuned tobe outstanding in perpetuity, the tax savings i he tax ate times retest payment. k * D, The present value ofthis perpetual savings is tkDMK = 1D, 65, In this set of problems, is ood for shareholders? Why? Is levering unlevering the firm something that shareholders can do for themselves? In what sense should shareholders pay a premium for shares of levered companies? From a macroeconomic point of view, is society better off if firms use more than zero debt (up to some prudent limit)? As a way of illustrating the usefulness of the M&M theory and consolidati _grasp of the mechanics, consider the following case and complete the workshe ‘On March 3, 1988, Beazer PLC (a British construction company) and Shearson Lehman Hutton, Ine, (an investment-banking firm) commenced a hostile tender offer to purchase all the outstanding stock of Koppers Company, Inc. a producer of construction materials, chemicals, and building products, Originally, the raiders offered S45 a share; subsequently, the offer was raised to $56 and then finally to S61 a share. The Koppers board asserted that the offers were inadequate and its management was reviewing the possibility of a major recapitalization To test the valuation effects ofthe recapitalization alternative, assume that Koppers could borrow a maximum of $1,738,095,000 at a pretax cost of debt of 10.5% and that the aggregate amount of debt will remain constant in perpetuity Thus, Koppers will take on additional debt of $1,565,686,000 (that is, S1,738,095,000 minus $172,409,000), Also assume that the proceeds of the loan would be paid as an extraordinary dividend to shareholders. EXhibit 1 presents Koppers” book- and market-value balance sheets, assuming the capital structure before recapitalization. Please complete the worksheet for the recapitalization alternativeEXHIBIT 4 | _Koppers Company, Inc. (values in thousands) Betore after Recapitalization Recapitalization Book-Value Balance Sheets a cee 7 Structuri tress ae]: seas vee Policy: L (Comman equity 480.874 Toll apt 5 813009 — and Eval ‘Market-Value Balance Sheets Net working eaptal 8 212459, —s Food assets 1.618.081 - ; PV debt tax shield 58.619 —— : Total assets 1,889,159 ——_ : Long-term det 172,408 — Defered taxes, ete = ——— Prefered stock CCommn equity Total capita 51,889,169 4 Number of shares 28,128 Price per share 6050 Value to Public Shareholders Cash recaived Value of shares Tota Total per share