An Introduction To Debt Policy And Value
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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 amortization
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.
(Table format and content from case)
0% debt
25% debt
50% debt
Pure business cash flows
$2,103
$2,103
$2,103
Taxes – 34%
$(715)
$(715)
$(715)
EBIAT
$1,388
$1,388
$1,388
+depreciation
– capital exp
$(500)
$(500)
$(500)
Cash flow
$1,388
$1,388
$1,388
Un-levered beta