AN INTRODUCTION TO DEBT POLICY AND VALUE
Antonius Cliff Setiawan 29119033
Azharry Adha 29119231
Suryanti Rahayu 29119108
Kevin 29119157
Lecturer: Prof. Dr. Ir. Sudarso Kaderi Wiryono DEA
MASTER BUSINESS OF ADMINISTRATION
INSTITUT TEKNOLOGI BANDUNG
2019-2020
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 (i.e.,
its weighted-average cost of capital) or the cash flows of the firm.
1. Please fill in the following:
Problem 1: Value of Assets
0% Debt/ 25% Debt/ 50% Debt/
100% Equity 75% Equity 50% Equity
Book Value of Debt - $ 2.500,00 $ 5.000,00
Book Value of Equity $ 10.000,00 $ 7.500,00 $ 5.000,00
Market Value of Debt - $ 2.500,00 $ 5.000,00
Market Value of Equity $ 10.000,00 $ 8.350,00 $ 6.700,00
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% 23,04% 42,74%
Equity 100% 76,96% 57,26%
Unlevered Beta 80,00% 80,00% 80,00%
Levered Beta 80,00% 95,81% 119,40%
Risk-Free Rate 5,00% 5,00% 5,00%
Market Premium 6,00% 6,00% 6,00%
Cost of Equity 9,80% 10,75% 12,16%
Cost of Debt 3,30% 3,30% 3,30%
Weighted-Average Cost of Capital 9,80% 9,03% 8,38%
EBIT $ 1.485,00 $ 1.485,00 $ 1.485,00
Taxes (@ 34%) $ 504,90 $ 504,90 $ 504,90
EBIAT $ 980,10 $ 980,10 $ 980,10
+ Depreciation $ 500,00 $ 500,00 $ 500,00
- Capital exp. $ (500,00) $ (500,00) $ (500,00)
+ Change in net working capital - - -
Free Cash Flow $ 980,10 $ 980,10 $ 980,10
Value of Assets (FCF/WACC) $ 10.001,02 $ 10.851,11 $ 11.701,19
Why does the value of assets change? Where, specifically, do the 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.
Problem 2: Value of Equity and Debt
0% Debt/ 25% Debt/ 50% Debt/
100% Equity 75% Equity 50% Equity
Cash flow to creditors:
Interest $ - $ 125,00 $ 250,00
Pretax cost of debt 0,05 0,05 0,05
Value of debt: (CF/rd) $ - $ 2.500,00 $ 5.000,00
Cash flow to shareholders:
EBIT $ 1.485,00 $ 1.485,00 $ 1.485,00
- Interest - $125 $250
Pretax profit $ 1.485,00 $ 1.360,00 $ 1.235,00
Taxes (@ 34%) $ 504,90 $ 462,40 $ 419,90
Net income $ 980,10 $ 897,60 $ 815,10
+ Depreciation $ 500,00 $ 500,00 $ 500,00
- Capital exp. $ (500,00) $ (500,00) $ (500,00)
+ Change in net working capital - - -
- Debt amortization - - -
Residual cash flow $ 980,10 $ 897,60 $ 815,10
Cost of equity 9,80% 10,75% 12,16%
Value of equity (RCF/k e) $ 10.001,02 $ 8.350,93 $ 6.700,82
Value of equity plus value of debt $ 10.001,02 $ 10.850,93 $ 11.700,82
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
Problem 3: Business Flows and Financing Effects
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
+ Depreciation $ 500 $ 500 $ 500
- Capital exp. $ (500) $ (500) $ (500)
+ Change in net working capital $ - $ - $ -
Cash Flow $ 980 $ 980 $ 980
Unlevered Beta 0,8 0,8 0,8
Risk-Free Rate 0,05 0,05 0,05
Market Premium 0,060 0,060 0,060
Unlevered WACC 9,80% 9,80% 9,80%
Value of Pure Business Flows:
(FCF/Unlevered WACC) $ 10.001,02 $ 10.001,02 $ 10.001,02
Financing Cash Flows
Interest $ - $ 125,00 $ 250,00
Tax Reduction $ - $ 42,50 $ 85,00
Pretax Cost of Debt 0,05 0,05 0,05
Value of Financing Effect:
(Tax Reduction/Pretax Cost of Debt) $ - $ 850,00 $ 1.700,00
Total Value (Sum of Values of
Pure Business Flows and Financing Effects) $ 10.001,02 $ 10.851,02 $ 11.701,02
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 proceeds from the loans in 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 change in the number of shares:
Share price = Total market value of equity
(Original shares - Repurchased shares)
But by rewriting the equation, we can put it in a form that can be solved:
Share price = Total market value of equity + Cash paid out
Number of original shares
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 $ 10.000,00 $ 10.850,00 $ 11.700,00
Cash Paid Out $ - $ - $ -
$ 10.000,00 $ 10.850,00 $ 11.700,00
Number of Original Shares 1.000 1.000 1.000
Total Value Per Share $ 10,00 $ 10,85 $ 11,70
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?
Yes, as we have learn, 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.
But Leverage is not something that shareholders can do by themselves the one who can do
leveraging is in the hand of the firms and executive.
Shareholders should pay a premium for shares of levered companies because levered companies
enjoy lower weighted average cost of capital. With a lower weighted average cost of capital, the
levered companies will be able to maximize profits on each project, maximize shareholders'
wealth, and maximize firm value. Hence it is reasonable for the shareholder to pay for a
premium.
6. From a macroeconomic point of view, is society better off if firms use more than zero debt
(up to some prudent limit)?
If firms use more debt from the zero point, managers or owners of the firms can get extra funds
to operate and the additional resources create value in real market. Also, from the investors’
point of view in capital market, they are able to earn more interests. Not only from the
perspectives of business operation, but also financial perspective of capital structure, debt is less
risky than harnessing equity methods in the long run.
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
Koppers Company, Inc.
(values in thousands)
Before After
Recapitalization Recapitalization
New Debt $ 1.565.686,00
Book Value Balance Sheets
Net working capital $ 212.453,00 $ 212.453,00
Fixed assets $ 601.446,00 $ 601.446,00
Total assets $ 813.899,00 $ 813.899,00
Additional debt
Long-term debt $ 172.409,00 $ 1.738.095,00
Deferred taxes, etc. $ 195.616,00 $ 195.616,00
Preferred stock $ 15.000,00 $ 15.000,00
Common equity $ 430.874,00 $ (1.134.812,00)
Total capital $ 813.899,00 $ 813.899,00
Market-Value Balance Sheets
Net working capital $ 212.453,00 $ 212.453,00
Fixed assets $ 1.618.081,00 $ 1.618.081,00
PV debt tax shield $ 58.619,00 $ 590.952,30
Total assets $ 1.889.153,00 $ 2.421.486,30
Long term debt $ 172.409,00 $ 1.738.095,00
Deferred taxes, etc. $ - $ -
Preferred stock $ 15.000,00 $ 15.000,00
Common equity $ 1.701.744,00 $ 668.391,30
Total capital $ 1.889.153,00 $ 2.421.486,30
Number of shares $ 28.128,00 $ 28.128,00
Price per share $ 60,50 $ 23,76
Value to Public Shareholders
Cash received $ - $ 1.565.686,00
Value of shares $ 1.701.744,00 $ 668.391,30
Total $ 1.701.744,00 $ 2.234.077,30
Total per share $ 60,50 $ 79,43
