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 difficult to reach the optimum since risk factors and debt levels change over time.

2

(Table format and content from case)

0% debt 25% debt 50% debt

Cash flow to creditors:

Interest 0 $175 $350

Pre- tax cost of debt 0.07 0.07 0.07

Value of debt: CF/rd 0 $2,500 $5,000

Cash flow to shareholders:

EBIT $2,103 $2,103 $2,103

- interest 0 $(175) $(350)

Pretax profit $2,103 $1,928 $1,753

Taxes - 34% $715 $655.5 $596

Net income $1,388 $1,272.5 $1,157

+ depreciation $500 $500 $500

- Cap Exp $(500) $(500) $(500)

- debt amortization 0 0 0

Residual cash flow $1,388 $1,272.5 $1,157

Cost of equity 13.88% 15.4% 20.8%

Value of equity: CF/re $10,000 $8,263 $5,562.5

Value of firm = value of debt + value of equity 0+10,000

= $10,000 $2,500+ 8,263

= $10,763 $5,000+ 5,562.5

$10.562.5

As the level of debt rises, a grater portion of the firm is debt value and thus a greater share of cash flow , mainly in terms of interest, goes to bondholders and creditors. More debt simply means that the value of the firm is split up more in favor of creditors than stock holders and it is reflected in the lower value of equity. However, it is just a matter of division of value but over all the value of the firm has risen with debt making it beneficial to both equity holders and creditors. Yet it is interesting to not that beyond the optimal debt point (when asset values start decreasing as more debt is added) the value of equity starts falling but the value of debt still increases.

3

(Table format and content from case)

0% debt 25% debt 50% debt

Pure business cash flows

EBIT $2,103 $2,103 $2,103

Taxes - 34% $(715) $(715) $(715)

EBIAT $1,388 $1,388 $1,388

+depreciation $500 $500 $500

- capital exp $(500) $(500) $(500)

Cash flow $1,388 $1,388 $1,388

Un-levered beta 0.8 0.8 0.8