31.An Introduction to Debt

31
CASE
425
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? If so,
for whom? If not, then why do so many executives concern themselves with leverage?
If leverage affects value, then it should cause changes in either the discount rate
of the firm (that is, its weighted-average cost of capital) or the cash flows of the firm.
1. Please fill in the following:
0% Debt/ 25% Debt/ 50% Debt/
100% Equity 75% Equity 50% Equity
Book Value of Debt –– $2,500 $5,000
Book Value of Equity $10,000 $7,500 $5,000
Market Value of Debt –– $2,500 $5,000
Market Value of Equity $10,000 $8,350 $6,700
Pretax Cost of Debt 5.00% 5.00% 5.00%
After-Tax Cost of Debt 3.30% 3.30% 3.30%
Market Value Weights of
Debt 0%
Equity 100%
Levered Beta 0.80
Risk-Free Rate 5.0% 5.0% 5.0%
Market Premium 6.0% 6.0% 6.0%
Cost of Equity
Weighted-Average Cost of Capital
EBIT $1,485 $1,485 $1,485
Taxes (@ 34%)
This note was prepared by Robert F. Bruner. It was written as a basis for class discussion rather than to
illustrate effective or ineffective handling of an administrative situation. Copyright © 1989 by the University

of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an
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(Continued)
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426 Part Six Management of the Corporate Capital Structure
(Continued)
0% Debt/ 25% Debt/ 50% Debt/
100% Equity 75% Equity 50% Equity
EBIAT
ϩ Depreciation $500 $500 $500
Ϫ Capital exp. ($500) ($500) ($500)
ϩ Change in net working capital –– –– ––
Free Cash Flow
Value of Assets (FCF/WACC)
Why does the value of assets change? Where, specifically, do those changes
occur?
2. In finance, as in accounting, the two sides of the balance sheet must be equal. In
the previous problem, we valued the asset side of the balance sheet. To value the
other side, we must value the debt and the equity, and then add them together.
0% Debt/ 25% Debt/ 50% Debt/
100% Equity 75% Equity 50% Equity
Cash flow to creditors:
Interest –– $125 $250
Pretax cost of debt 5.0% 5.0% 5.0%
Value of debt:
(Int/K
d
)

Cash flow to shareholders:
EBIT $1,485 $1,485 $1,485
Interest –– $125 $250
Pretax profit
Taxes (@ 34%)
Net income
ϩ Depreciation $500 $500 $500
Ϫ Capital exp. ($500) ($500) ($500)
ϩ Change in net working capital –– –– ––
Ϫ Debt amortization –– –– ––
Residual cash flow
Cost of equity
Value of equity (RCF/K
e
)
Value of equity plus value of debt
As the firm levers up, how does the increase in value get apportioned between
the creditors and the shareholders?
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Case 31 An Introduction to Debt Policy and Value 427
3. In the preceding problem, we divided the value of all the assets between two
classes of investors: creditors and shareholders. This process tells us where the
change in value is going, but it sheds little light on where the change is coming
from. Let’s divide the free cash flows of the firm into pure business flows and cash
flows resulting from financing effects. Now, an axiom in finance is that you should
discount cash flows at a rate consistent with the risk of those cash flows. Pure
business flows should be discounted at the unlevered cost of equity (i.e., the cost
of capital for the unlevered firm). Financing flows should be discounted at the rate
of return required by the providers of debt.
0% Debt/ 25% Debt/ 50% Debt/

100% Equity 75% Equity 50% Equity
Pure Business Cash Flows:
EBIT $1,485 $1,485 $1,485
Taxes (@ 34%) $505 $505 $505
EBIAT $980 $980 $980
ϩ Depreciation $500 $500 $500
Ϫ Capital exp. ($500) ($500) ($500)
ϩ Change in net working capital –– –– ––
Free Cash Flow $980 $980 $980
Unlevered Beta 0.8 0.8 0.8
Risk-Free Rate 5.0% 5.0% 5.0%
Market Premium 6.0% 6.0% 6.0%
Unlevered WACC
Value of Pure Business Flows:
(FCF/Unlevered WACC)
Financing Cash Flows
Interest
Tax Reduction
Pretax Cost of Debt 5.0% 5.0% 5.0%
Value of Financing Effect:
(Tax Reduction/Pretax Cost of Debt)
Total Value (Sum of Values of
Pure Business Flows and Financing Effects)
The first three problems illustrate one of the most important theories in
finance. This theory, developed by two professors, Franco Modigliani and
Merton Miller, revolutionized the way we think about capital structure policies.
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428 Part Six Management of the Corporate Capital Structure
The M&M theory says:
4. What remains to be seen, however, is whether shareholders are better or worse off

with more leverage. Problem 2 does not tell us because there we computed total
value of equity, and shareholders care about value per share. Ordinarily, total value
will be a good proxy for what is happening to the price per share, but in the case of
a relevering firm, that may not be true. Implicitly, we assumed that, as our firm in
problems 1–3 levered up, it was repurchasing stock on the open market (you will
note that EBIT did not change, so management was clearly not investing the pro-
ceeds from the loans into cash-generating assets). We held EBIT constant so that
we could see clearly the effect of financial changes without getting them mixed up
in the effects of investments. The point is that, as the firm borrows and repurchases
shares, the total value of equity may decline, but the price per share may rise.
Now, solving for the price per share may seem impossible because we are
dealing with two unknowns—share price and the change in the number of shares:
But by rewriting the equation, we can put it in a form that can be solved:
Referring to the results of problem 2, let’s assume that all the new debt is
equal to the cash paid to repurchase shares. Please complete the following table:
0% Debt/ 25% Debt/ 50% Debt/
100% Equity 75% Equity 50% Equity
Total Market Value of Equity
Cash Paid Out
# Original Shares 1,000 1,000 1,000
Total Value Per Share
Share price ϭ
Original market value of equity ϩ Value of financing effect
Number of original shares
Share price ϭ
Market value of equity
Original shares Ϫ Repurchased shares
Value of Value of Value of Value of Value of
assets ϭ debt ϩ equity ϭ unlevered ϩ debt tax
firm shields

1
^^ ^
Problem 1 Problem 2 Problem 3
1
Debt tax shields can be valued by discounting the future annual tax savings at the pretax cost of debt.
For debt, that is assumed to be outstanding in perpetuity, the tax savings is the tax rate, t, times the
interest payment, k ϫ D. The present value of this perpetual savings is tkD/k ϭ tD.
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5. In this set of problems, is leverage good 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?
6. From a macroeconomic point of view, is society better off if firms use more than
zero debt (up to some prudent limit)?
7. As a way of illustrating the usefulness of the M&M theory and consolidating your
grasp of the mechanics, consider the following case and complete the worksheet.
On March 3, 1988, Beazer PLC (a British construction company) and Shearson
Lehman Hutton, Inc. (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 $45 a share; subsequently, the offer was raised to $56 and then finally to
$61 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 of the 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 $l,565,686,000 (that is,
$1,738,095,000 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.
Case 31 An Introduction to Debt Policy and Value 429
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430 Part Six Management of the Corporate Capital Structure
EXHIBIT 1 | Koppers Company, Inc. (values in thousands)
Before After
Recapitalization Recapitalization
Book-Value Balance Sheets
Net working capital $ 212,453
Fixed assets 601,446
Total assets 813,899
Long-term debt 172,409
Deferred taxes, etc. 195,616
Preferred stock 15,000
Common equity 430,874
Total capital $ 813,899
Market-Value Balance Sheets
Net working capital $ 212,453
Fixed assets 1,618,081
PV debt tax shield 58,619
Total assets 1,889,153
Long-term debt 172,409
Deferred taxes, etc. ––
Preferred stock 15,000
Common equity 1,701,744
Total capital $1,889,153
Number of shares 28,128
Price per share $ 60.50
Value to Public Shareholders
Cash received $ ––

Value of shares $1,701,744
Total $1,701,744
Total per share $ 60.50
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