This spreadsheet supports STUDENT analysis of the case An Introduction to Debt Policy and Value (Case 31).

This spreadsheet was prepared by Robert F. Bruner. Copyright 1991 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved.
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Rev. Jun. 20, 2012

Problem 1: Value of Assets

0% Debt/ 25% Debt/ 50% Debt/

100% Equity 75% Equity 50% Equity
Book Value of Debt - $2,500 $5,000
Book Value of Equity $10,000 $7,500 $5,000

Market Value of Debt - $2,500 $5,000

Market Value of Equity $10,000 $8,350 $6,700

Pretax Cost of Debt 5.00% 5.00% 5.00%

After-Tax Cost of Debt 3.30% 3.30% 3.30%

Market Value Weights of

Debt 0%
Equity 100%
Levered Beta 0.80
Risk-Free Rate 5.0% 5.0% 5.0%
Market Premium 6.0% 6.0% 6.0%
Cost of Equity
Weighted-Average Cost of Capital
EBIT $1,485 $1,485 $1,485
Taxes (@ 34%)
EBIAT
+ Depreciation $500 $500 $500
- Capital exp. ($500) ($500) ($500)
+ Change in net working capital - - -
Free Cash Flow

Value of Assets (FCF/WACC)

Problem 2: Value of Equity and Debt

0% Debt/ 25% Debt/ 50% Debt/

100% Equity 75% Equity 50% Equity

Cash flow to creditors:

Interest - $125 $250
Pretax cost of debt 5.0% 5.0% 5.0%
Value of debt:
(Int/Kd)

Cash flow to shareholders:

EBIT $1,485 $1,485 $1,485
Interest - $125 $250
Pretax profit
Taxes (@ 34%)
Net income
+ Depreciation $500 $500 $500
- Capital exp. ($500) ($500) ($500)
+ Change in net working capital - - -
- Debt amortization - - -
Residual cash flow

Cost of equity

Value of equity (RCF/Ke)

Value of equity plus value of debt

Problem 3: Business Flows and Financing Effects

0% Debt/ 25% Debt/ 50% Debt/

100% Equity 75% Equity 50% Equity

Pure Business Cash Flows:

EBIT $1,485 $1,485 $1,485
Taxes (@ 34%) $505 $505 $505
EBIAT $980 $980 $980
+Depreciation $500 $500 $500
-Capital exp. ($500) ($500) ($500)
+Change in net working capital - - -
Free Cash Flow $980 $980 $980

Unlevered Beta 0.8 0.8 0.8

Risk-Free Rate 5.0% 5.0% 5.0%
Market Premium 6.0% 6.0% 6.0%
Unlevered WACC

Value of Pure Business Flows:

(FCF/Unlevered WACC)

Financing Cash Flows

Interest
Tax Reduction

Pretax Cost of Debt 5.0% 5.0% 5.0%

Value of Financing Effect:

(Tax Reduction/Pretax Cost of Debt)

Total Value (Sum of Values of

Pure Business Flows and Financing Effects)
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 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 Original Market Value of

Price = Value of Equity + Financing Effect
# of 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:

0% Debt/ 25% Debt/

100% Equity 75% Equity

Total Market Value of Equity

Cash Paid Out
# Original Shares 1,000 1,000
Total Value Per Share
50% Debt/
50% Equity

1,000
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.

_x000C_ Exhibit 1

AN INTRODUCTION TO DEBT POLICY AND VALUE

Koppers Company, Inc.

Before After
Recapitalization Recapitalization

Book Value Balance Sheets

Net working capital $ 212,453
Fixed assets 601,446
Total assets 813,899

Long-term debt 172,409

Deferred taxes, etc. 195,616
Preferred stock 15,000
Common equity 430,874
Total capital $ 813,899

Market-Value Balance Sheets

Net working capital $ 212,453
Fixed assets 1,618,081
PV debt tax shield 58,619
Total assets 1,889,153

Long term debt 172,409

Deferred taxes, etc. -
Preferred stock 15,000
Common equity 1,701,744
Total capital $ 1,889,153
Number of shares 28,128
Price per share $ 60.50

Value to Public Shareholders

Cash received $ -
Value of shares $ 1,701,744
Total $ 1,701,744
Total per share $ 60.50