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

1

(Table format and content from case)

0% debt/100% equity 25%debt/75% equity 50%debt/50% equity

BV of debt 0 $2,500 $5,000

BV of equity $10,000 $7,500 $5,000

MV of debt 0 $2,500 $5,000

MV of equity $10,000 $8,350 $6,700

Pretax cost of debt 0.07 0.07 0.07

After-tax cost of debt 0.0462 0.0462 0.0462

Market Weight of Debt 0 0.23 0.43

Market Weight of Equity 1.0 0.77 0.57

Un-levered Beta 0.8 0.8 0.8

Risk free rate 0.07 0.07 0.07

Market premium 0.086 0.086 0.086

Cost of equity 13.88% 15.4% 20.8%

WACC 13.88% 13.5% 13.8%

EBIT $2,103 $2,103 $2,103

- Taxes - 34% $1,388 $1,388 $1,388

EBIAT $1,388 $1,388 $1,388

+ Depreciation $500 $500 $500

- Cap exp. $(500) $(500) $(500)

FCF 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

Rs = r0 + D/E(r0-rb) = 13.88 + 1/3(13.88- 7) = 16.1

Alternatively:

Bl = Bu {1+ (1-T) (D/E)} = .8{1+ (1- .34) (1/3) = .976

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

Rs = r0 + D/E(r0-rb) = 13.88 + 1(13.88- 7) = 20.8%

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.

2

(Table format and content from case)

0% debt 25% debt 50% debt

Cash flow to creditors:

Interest 0 $175 $350

Pre- tax cost of debt 0.07 0.07 0.07

Value of debt: CF/rd 0 $2,500 $5,000

Cash flow to shareholders:

EBIT $2,103 $2,103 $2,103

- interest 0 $(175) $(350)

Pretax profit $2,103 $1,928 $1,753

Taxes - 34% $715 $655.5 $596

Net income $1,388 $1,272.5 $1,157

+ depreciation $500 $500 $500

- Cap Exp $(500) $(500) $(500)

- debt