An Introduction to Debt Policy and Value
Join now to read essay 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
(Table format and content from case)
0% debt/100% equity
25%debt/75% equity
50%debt/50% equity
BV of debt
$2,500
$5,000
BV of equity
$10,000
$7,500
$5,000
MV of debt
$2,500
$5,000
MV of equity
$10,000
$8,350
$6,700
Pretax cost of debt
After-tax cost of debt
0.0462
0.0462
0.0462
Market Weight of Debt
Market Weight of Equity
Un-levered Beta
Risk free rate
Market premium
0.086
0.086
0.086
Cost of equity
13.88%
15.4%
20.8%
13.88%
13.5%
13.8%
$2,103
$2,103
$2,103
– Taxes – 34%
$1,388
$1,388
$1,388
EBIAT
$1,388
$1,388
$1,388
+ Depreciation
– Cap exp.
$(500)
$(500)
$(500)
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
Alternatively:
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
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.
(Table format and content from case)
0% debt
25% debt
50% debt
Cash flow to creditors:
Interest
Pre- tax cost of debt
Value of debt: CF/rd
$2,500
$5,000
Cash flow to shareholders:
$2,103
$2,103
$2,103
– interest
$(175)
$(350)
Pretax profit
$2,103
$1,928
$1,753
Taxes – 34%
$655.5
Net income
$1,388
$1,272.5
$1,157
+ depreciation
– Cap Exp
$(500)
$(500)
$(500)
– debt