How does debt create value?

● Debt costs are cheaper than equity costs. So the value of equity increases
because more low-cost capital is used to create the same return.
● The cost of debt, interest, can be deducted from taxes so that the value is
increased compared to direct dividends.
● Debt create financial leverage. The use of financial leverage to control a greater
amount of assets (by borrowing money) will cause the returns on the owner's
cash investment to be amplified. That is, with financial leverage:
- an increase in the value of the assets will result in a larger gain on the
owner's cash, when the loan interest rate is less than the rate of increase
in the asset's value
- a decrease in the value of the assets will result in a larger loss on the
owner's cash
Problem 1 - Value of Assets
Why does the value assets
change?
Because the leverage change the
WACC. The cost of equity is typically
higher than the cost of debt, so increasing
debt financing usually reduce WACC &
increase company value.

Where, specifically, do those

changes occur?

The changes occur on the

proportion between debt & equity
Problem 2 - Value of Debt &
Equity As the firm levers up, how
does the increase in value get
apportioned between the
creditors and the
shareholders?
The increase of value apportioned
by the market value weight of debt
to creditors and market value
weight of equity to shareholders
Problem 3 - Business Flows and Financing
Effects
Problem 4 - Business Flows and
Financing Effects
We can calculate share price with equation

Share price = Original market value of equity + Value of

financing effect Number of original
shares

Cash paid out = total value in

problem 3

Total value/share = cash paid

out/ number of origial share
Problem 5 - Is Levered good for
shareholders?
Is levered good for shareholders? Why?

Yes, as seen as problem 4 adding debt increase the total value per share, which will
lead to increase value for shareholders. WACC tends to be lower for more leveraged
companies as long as they are able to service the debt. A lower WACC increases the calculated
present value of anticipated future cash flow, which is projected to increase the share price.

Is levering/unlevering the firm something that shareholders

can do for themselves?
Whether to leverage the firm or not is normally a
management/executive function instead of a shareholder function
In what sense should shareholders pay a premium for shares of levered
companies?
When a company is levered, the WACC is lower and company can
maximize profits and maximize shareholders wealth, but the risk of the
firm also increases. Hence it is reasonable for the shareholder to pay a
Problem 6 - Macroeconomic Point of
View
From a macroeconomic point of view, is society better off if
firms use more than zero debt (up to some prudent limit)?
Yes, for some reason:

● Debt can fuel growth of company by maximizing it’s profit (resource

allocation)
● Tax deduction allows business to use the money saved to grow the business.
● Debt maintain company ownership. Management has complete control over
the decisions made on behalf of the company.
● Giving managers a need to stay controlled with the free cash flow
● In general debt provide less risk than equity
Problem 7 - Recapitalization Alternatives,
Koppers Company, Inc.

● Beazer PLC & Searson Lehman Hurton commenced a hostile tender offer
to purchase all the outstanding stock of Koppers Company, Inc.
● Raiders offered $45 a share, raised to $56 and then finally reaching $61 a
share
● Assume that Koppers could borrow a maximum of $1,738,095,000 at a
pretax cost of debt of 10.5%
● Koppers will take on additional debt of $l,565,686,000 (that is,
$1,738,095,000 minus $172,409,000).
Problem 7 - Recapitalization, Koppers
Company, Inc.
Problem 7 - Recapitalization, Koppers
Company, Inc.