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AN INTRODUCTION TO DEBT POLICY AND VALUE Many factors determine how much debt a firm takes on. Cl the firm. Does borrowing create value? If so, for whom? I leverage? If leverage affects value, then it should cause changes in ei capital) or the cash flows of the firm. 1. Please fill in the following: 0% Debt 25% Debt 50% Debt 100% Equity 75% Equity 50% Equity Book Value $ $ 2,500 $ 5,000 Book Value $ 10,000 $ 7,500 $ 5,000 Market Valu s - $ 2,500 $ 5,000 Market Valu s 10,000 $ 8,350 $ 6,700 Pretax Cost 5.00% 5.00% 5.00% After-Tax Cost of Debt Market Value Weights of Debt Equity 100% Unlevered B 0.80 0.80 0.80 Levered Bet 0.80 Risk-Free R 5.00% 5.00% 5.00% Market Pren 6.00% 6.00% 6.00% Cost of Equity Weighted Average Cost of Capital EBIT $ 1,485.00 $ 1,485.00 $ 1,485.00 - Taxes (@34%) EBIAT + Depreciati s 500.00 $ 500.00 $ 500.00 Capital Ex $ (500.00 $ (500.00) $ (500.00) Change inns $ $ Free Cash Flow Value of Assets (FCF/WACC) Why does the value of assets change? Where, specifically, 0% 2. In finance, as in accounting, the two sides of the ba of the balance sheet. To value the other side, we mu 0% Debt 25% Debt 50% Debt 100% Equity 75% Equity 50% Equity Cash Flow $ $ 125.00 $ 250.00 Pretax Cost 5.00% 5.00% 5.00% Value of Debt: (CF/rd) Cash Flow to Shareholders: EBIT $ 1,485.00 $ 1,485.00 $ 1,485.00 Interest $ $ (125.00 $ 250.00) Pretax Profit Taxes (@34%) Net Income + Deprecia s 500.00 $ 500.00 $ 500.00 - Capital E: S (500.00) $ (500.00) S (500.00) + Change is $ $ - Debt Am $ $ S Residual Cash Flow Cost of Equity (from Prob. 1) Value of Equity (CF/re) Value of Equity plus value of debt As the firm levers up, how does the increase in value A A 3. In the preceding problem, we divided the value of all the assets between two classes of investorscreditors 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. 0% Debt 25% Debt 50% Debt 100% Equity 75% Equity 50% Equity Pure Business Cash Flows: EBIT $ 1,485.00 $ 1,485.00 $ 1.485.00 Taxes @:S 504.90 $ 504.90 $ 504.90 EBIAT $ 980.10 $ 980.10 $ 980.10 +Depreciat $ 500.00 $ 500.00 $ 500.00 Capital E: $ (500.00 $ (500.00) $ (500.00) Cash Flow $ 980.10 $ 980.10 $ 980.10 Unlevered E 0.80 0.80 0.80 Risk-Free R 5.00% 5.00% 5.00% Market Pren 6.00% 6.00% 6.00% Unlevered WACC Value of Pure Business Flows: (CF/Unlevered WACC) Financing Cash Flows Interest (from Prob. 2) Tax Reduction Pretax Cost 5.00% 5.00% 5.00% Value of Financing Effect: (Tax Reduction Pretax Cost of Debt) Total Value (Sum of Values of Pure Business Flows and Financing Effects) The first three problems illustrate one of the most important theories in finance. This theory, developed by two professors, Franco Modigliani and Merton Miller, revolutionized 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 Problem 1 Problem 2 Problem 3 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 work sheet. 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 per share, subsequently the offer was raised to $56, and then finally $61 per share. The Koppers board generally 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 a maximum of $1,738,095,000 at a pretax cost of debt of 10.5 percent and that the aggregate amount of debt will remain constant in perpetuity. Thus, Koppers will take on additional debt of $1,565,686,000 (I.e., $1,738,095,000 - $172.409,000). Also assume that the proceeds of the loan would be paid as an extraordinary dividend to shareholders. Exhibit 1 presents Koppers' book- and market-value balance sheets assuming the capital structure before recapitalization. Please complete the work sheet for the recapitalization alternative. Exhibit 1 AN INTRODUCTION TO DEBT POLICY AND VALU Koppers Company, Inc. (values are in thousands) Before After Recapitalization Changes Recapitalization Book Value Balance Sheets Net working S 212,453 Fixed assets 601,446 Total assets 813,899 Long-term d 172,409 Deferred tax 195,616 Preferred stc 15,000 Common eq 430,874 Total capital $ 813,899 Market-Value Balance Sheets Net working $ 212,453 Fixed assets 1,618,081 PV debt tax 58,619 Total assets 5 1,889,153 Long term d $ 172,409 Deferred tax Preferred stc 15,000 Common eq 1.701.744 Total capitals 1,889,153 Number of s 28.128 Price per sh: 60.50 Value to Public Shareholders Cash receive 0 Value of sha $ 1,701,744 Total 1,701,744 Total per sh: $ 60.50 111 0 AN INTRODUCTION TO DEBT POLICY AND VALUE Many factors determine how much debt a firm takes on. Cl the firm. Does borrowing create value? If so, for whom? I leverage? If leverage affects value, then it should cause changes in ei capital) or the cash flows of the firm. 1. Please fill in the following: 0% Debt 25% Debt 50% Debt 100% Equity 75% Equity 50% Equity Book Value $ $ 2,500 $ 5,000 Book Value $ 10,000 $ 7,500 $ 5,000 Market Valu s - $ 2,500 $ 5,000 Market Valu s 10,000 $ 8,350 $ 6,700 Pretax Cost 5.00% 5.00% 5.00% After-Tax Cost of Debt Market Value Weights of Debt Equity 100% Unlevered B 0.80 0.80 0.80 Levered Bet 0.80 Risk-Free R 5.00% 5.00% 5.00% Market Pren 6.00% 6.00% 6.00% Cost of Equity Weighted Average Cost of Capital EBIT $ 1,485.00 $ 1,485.00 $ 1,485.00 - Taxes (@34%) EBIAT + Depreciati s 500.00 $ 500.00 $ 500.00 Capital Ex $ (500.00 $ (500.00) $ (500.00) Change inns $ $ Free Cash Flow Value of Assets (FCF/WACC) Why does the value of assets change? Where, specifically, 0% 2. In finance, as in accounting, the two sides of the ba of the balance sheet. To value the other side, we mu 0% Debt 25% Debt 50% Debt 100% Equity 75% Equity 50% Equity Cash Flow $ $ 125.00 $ 250.00 Pretax Cost 5.00% 5.00% 5.00% Value of Debt: (CF/rd) Cash Flow to Shareholders: EBIT $ 1,485.00 $ 1,485.00 $ 1,485.00 Interest $ $ (125.00 $ 250.00) Pretax Profit Taxes (@34%) Net Income + Deprecia s 500.00 $ 500.00 $ 500.00 - Capital E: S (500.00) $ (500.00) S (500.00) + Change is $ $ - Debt Am $ $ S Residual Cash Flow Cost of Equity (from Prob. 1) Value of Equity (CF/re) Value of Equity plus value of debt As the firm levers up, how does the increase in value A A 3. In the preceding problem, we divided the value of all the assets between two classes of investorscreditors 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. 0% Debt 25% Debt 50% Debt 100% Equity 75% Equity 50% Equity Pure Business Cash Flows: EBIT $ 1,485.00 $ 1,485.00 $ 1.485.00 Taxes @:S 504.90 $ 504.90 $ 504.90 EBIAT $ 980.10 $ 980.10 $ 980.10 +Depreciat $ 500.00 $ 500.00 $ 500.00 Capital E: $ (500.00 $ (500.00) $ (500.00) Cash Flow $ 980.10 $ 980.10 $ 980.10 Unlevered E 0.80 0.80 0.80 Risk-Free R 5.00% 5.00% 5.00% Market Pren 6.00% 6.00% 6.00% Unlevered WACC Value of Pure Business Flows: (CF/Unlevered WACC) Financing Cash Flows Interest (from Prob. 2) Tax Reduction Pretax Cost 5.00% 5.00% 5.00% Value of Financing Effect: (Tax Reduction Pretax Cost of Debt) Total Value (Sum of Values of Pure Business Flows and Financing Effects) The first three problems illustrate one of the most important theories in finance. This theory, developed by two professors, Franco Modigliani and Merton Miller, revolutionized 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 Problem 1 Problem 2 Problem 3 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 work sheet. 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 per share, subsequently the offer was raised to $56, and then finally $61 per share. The Koppers board generally 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 a maximum of $1,738,095,000 at a pretax cost of debt of 10.5 percent and that the aggregate amount of debt will remain constant in perpetuity. Thus, Koppers will take on additional debt of $1,565,686,000 (I.e., $1,738,095,000 - $172.409,000). Also assume that the proceeds of the loan would be paid as an extraordinary dividend to shareholders. Exhibit 1 presents Koppers' book- and market-value balance sheets assuming the capital structure before recapitalization. Please complete the work sheet for the recapitalization alternative. Exhibit 1 AN INTRODUCTION TO DEBT POLICY AND VALU Koppers Company, Inc. (values are in thousands) Before After Recapitalization Changes Recapitalization Book Value Balance Sheets Net working S 212,453 Fixed assets 601,446 Total assets 813,899 Long-term d 172,409 Deferred tax 195,616 Preferred stc 15,000 Common eq 430,874 Total capital $ 813,899 Market-Value Balance Sheets Net working $ 212,453 Fixed assets 1,618,081 PV debt tax 58,619 Total assets 5 1,889,153 Long term d $ 172,409 Deferred tax Preferred stc 15,000 Common eq 1.701.744 Total capitals 1,889,153 Number of s 28.128 Price per sh: 60.50 Value to Public Shareholders Cash receive 0 Value of sha $ 1,701,744 Total 1,701,744 Total per sh: $ 60.50 111 0