: E 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 concem 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) 0% Debl/ 100% Equity 75% Equity 50% Equity Book value of debt 0 $2,500 $5,000 Book value of equity $10,000 $7,500 $5,000 Market value of debt 0 $2,500 $5,000 Market value of equity $10,000 $8,350 $6,700 Pretax cost of debt 5.0% 5.0% 5.0% After-tax cost of debt 3.3% 3.3% 3.3% Market value weights of: Debt - = Equity es cs Levered beta = = Risk-free rate 5.0% 5.0% Market premium 6.0% 6.0% Cost of equity = — = Weighted-average cost of capital (WACC) = = = EsiT $1,485 $1,485 $1,485 = Taxes (@ 34%) - - = EBIAT = = _ + Depreciation $500 $ 500 § 500 = Capital expense $ (600) $ (600) $ (600) Change in net working capital ° 0 0 Free cash flow - = = \Value of Assets (FCF/WACC) - = This note was prepared by Robert F. Bruner. It was writen asa basis for class discussion rather than to illus- trate effective or ineffective handling of an administrative situation, Copyright © 1989 by the University of ‘Virginia Darden School Foundation, Charioesile, VA. All ighs reserved. Toner copies, send an e-mail to [email protected]. No part ofthis publication may be reproduced, stored in a retrieval veadsheet, or transmitted in any form or by any means—electronic, mechanical, photo- ‘or otherwise—without the permission of the Darden School Foundation. Rev. 12105. 425 system, used in a sp copying, recording,436 Part Six Management of the Corporate Capital Structure Why does the value of assets change? Where, specifically, do those changes occur? 2. Infinance, 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 0 $ 125 $ 250 Pretax cost of debt 5.0% 5.0% 5.0% Value of debt: (Interest) - - - Cash flow to shareholders: EBIT $1,485 $1,485 $1,485 = Interest 0 $ (125) $ (250) Protax profit = = = Taxes (@ 34%) - - - Net income = = - + Depreciation $ 500 $ 500 $ 500 ~ Capital expense $ (600) § (500) $ (600) + Change in net working capital ° 0 0 = Debt amortization 0 0 0 Residual cash flow (ROF) - - - Cost of equity = - - Value of equity (RCF/ke) ot - - 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? 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 lite 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.Case 31 An Introduction to Debt Policy and Value 437 ee 0% Debt! 25% Debt! ‘50% Debt Ee 5 100% Equity 75% Equity 50% Equity Pure business, cash flows: EBIT $1,485 $1,485 $1,485 Taxes (@ 34%) $ (605) $ (605) $ (605) EBIAT $ 980 $ 980 $ 980 + Depreciation $ 500 $ 500 $ 500 — Capital expense $ (600) $ (500) $ (600) + Change in net working capital 0 0 0 Free cash flow (FCF) $ 980 $ 980 $ 980 Unlevered beta 8 8 8 Risk-free rate 5.0% 5.0% 5.0% Market premium 3 6.0% 6.0% 6.0% Unlevered WACC " ne = ae Value of pure business flows: (FCFiunlevered WACC) - - - Financing cash flows Interest - - - Tax reduction - - - Pretax cost of debt 5.0% 5.0% 5.0% Valve of financing effect: (Tax reduction/pretax cost of deb!) - = Total value (sum ofyalues of pure business flows and financing effects) - 2 ‘The first three problems illustrate one of the most important theories in finance. This theory, developed by two professors, Franco Modigliani and Merton Miller, revolution- ized the way we think about capital-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' a n Problem 1 Problem 2 Problem 3 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 ‘Debt tax shields can be valued by discounting the future annual tax savings at the pretax cost of debt For debi, that is assumed to be outstanding in perpetuity, the tax savings isthe tax rat, t, times the interest payment, k X D. The present value of this perpetual savings is tkD/k = tD.438 Part Six Management of the Corporate Capital Structure (you will note that EBIT did not change, so management was clearly not investing the proceeds 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, a 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: Market value of equity Original shares — Repurchased shares Share price But by rewriting the equation, we can put it in a form that can be solved: ____ Original market value of equity + Value of financing effect Share price = = OS 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 - = = Cash paid out a = am Number of original shares 4,000 1,000 1,000 Total value per share = = i ee 5. In this set of problems, is leverage good for shareholders? Why? Is levering/unlev- ering 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. Asa way of illustrating the usefulness of the M&M theory and consolidating your gasp 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 10 $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 @ 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i Case 31 An Introduction to Debt Policy and Value 439 will take on additional debt of $1,565,686,000 (that is, $1,738,095,000 minus $172,409,000). Also assume that the proceeds of the loan would be paid as an extraor- dinary 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 1 | Koppers Company, Inc. (values in thousands) ————_eaaaeaeoaeoeewyeE—EeEOEOee eS 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 pees Deferred taxes, etc. 195,616 Preferred stock ‘Common equity Total capital $ 813,899 Market-Value Balance Sheets : Net working capital $ 212,453 Tella fall Fixed assets 1,618,081 _—— Present value (PV) debt tax shield 58,619 Total assets $1,889,153 Long-term debt $ 172,409 Deferred taxes, etc. 0 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 0 Value of shares $1,701,744 Total 1,701,744 Total per share $ 60.50