This spreadsheet supports STUDENT analysis of the case, "An Introduction to

Debt Policy and Value" (Case 28).

Revised:
7-Mar-06
Copyright Darden Graduate Business School Foundation, Charlottesville VA.

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 concern themselves with leverage?
If leverage affects value, then it should cause changes in either the discount rate of the firm
(i.e., its weighted-average cost of capital) or the cash flows of the firm.
1. Please fill in the following:
0% Debt/
100% Equity
0
10000

25% Debt/
75% Equity
2500
7500

Market Value of Debt

Market Value of Equity

0
10000

2500
8350

Pretax Cost of Debt

7.00%

7.00%

After-Tax Cost of Debt

4.62%

4.62%

0%
100%
0.80
7.0%
8.6%

0%
100%
0.80
7.0%
8.6%

2103

2103

500
-500

500
-500

Book Value of Debt

Book Value of Equity

Market Value Weights of

Debt
Equity
Unlevered Beta
Risk-Free Rate
Market Premium
Cost of Equity
Weighted-Average Cost of Capital
EBIT
Taxes (@ 34%)
EBIAT
+ Depreciation
Capital Exp.
Free Cash Flow

Value of Assets (FCF/WACC)

Why does the value of assets change? Where, specifically, do the changes occur?

75% Equity

50% Debt/
50% Equity
5000
5000
5000
6700
7.00%
4.62%

0%
100%
0.80
7.0%
8.6%

2103

500
-500

2. In finance, 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.

Cash Flow to Creditors:

Interest
Pretax Cost of Debt
Value of Debt:
(CF/rd)
Cash Flow to Shareholders:
EBIT
Interest
Pretax Profit
Taxes (@ 34%)
Net Income
+ Depreciation
Capital Exp.
Debt Amortiz.
Residual Cash Flow

0% Debt/
100% Equity

25% Debt/
75% Equity

0
0.07

175
0.07

2103
0

2103
-175

500
-500
0

500
-500
0

Cost of Equity

Value of Equity (CF/re)

Value of Equity plus Value of Debt

As the firm levers up, how does the increase in value get apportioned between creditors and
shareholders?

75% Equity

50% Debt/
50% Equity

350
0.07

2103
-350

500
-500
0

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/
100% Equity

25% Debt/
75% Equity

2103
-715
1388
500
-500
1388

2103
-715
1388
500
-500
1388

0.8
7.0%
8.6%

0.8
7.0%
8.6%

7.0%

7.0%

Pure Business Cash Flows:

EBIT
Taxes (@ 34%)
EBIAT
+Depreciation
Capital Exp.
Cash Flow
Unlevered Beta
Risk-Free Rate
Market Premium
Unlevered WACC
Value of Pure Business Flows:
(CF/Unlevered WACC)
Financing Cash Flows
Interest
Tax Reduction
Pretax Cost of Debt
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
Assets =

Value of
Value of
Value of
Value of
Debt + Equity = Unlevered + Debt Tax
Firm
Shields

^
Problem 1

^
Problem 2

Problem 3

75% Equity

50% Debt/
50% Equity

2103
-715
1388
500
-500
1388
0.8
7.0%
8.6%

7.0%

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 (you will note that EBIT did not change, so
management was clearly not investing the proceeds from the loans in 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, as 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
unknownsshare price and change in the number of shares:
Share
Total Market
Price = Value of Equity
(Original - Repurchased
Shares Shares)

But by rewriting the equation, we can put it in a form that can be solved:

Share
Total Market
Cash
Price = Value of Equity + Paid Out
# 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:

Total Market Value

of Equity
Cash Paid Out
# Original Shares
Total Value Per Share

0% Debt/
100% Equity

25% Debt/
75% Equity

1000

1000

75% Equity

50% Debt/
50% Equity

1000

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 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
$l,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 VALUE
Koppers Company, Inc.

Before
Recapitalization
Book Value Balance Sheets
Net working capital
Fixed assets
Total assets
Long-term debt
Deferred taxes, etc.
Preferred stock
Common equity
Total capital

Market-Value Balance Sheets

Net working capital
Fixed assets
PV debt tax shield
Total assets
Long term debt
Deferred taxes, etc.

212,453
601,446
813,899
172,409
195,616
15,000
430,874
813,899

212,453
1,618,081
58,619
1,889,153
172,409
-

After
Recapitalization

Preferred stock
Common equity
Total capital

15,000
1,701,744
1,889,153

Number of shares
Price per share

28,128
60.50

Value to Public Shareholders

Cash received
Value of shares
Total
Total per share

$
$
$
$

1,701,744
1,701,744
60.50

Recapitalization