UV0070

Version 2.0

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
(that is, its weighted-average cost of 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 of debt 0 $2,500 $5,000
Book value of equity $10,000 $7,500 $5,000
Market value of debt 0 $2,500 $5,000
Market value of equity $10,000 $8,350 $6,700
Pretax cost of debt .05 .05 .05
After-tax cost of debt .033 .033 .033
Market value weights of:
Debt 0 ___
Equity 1.0 ___
Levered beta .8 ___ ___
Risk-free rate .05 .05 .05
Market premium .06 .06 .06
Cost of equity ___
Weighted-average cost of capital (WACC) ___
EBIT $1,485 $1,485 $1,485
− Taxes (@ 34%) ___
EBIAT ___
+ Depreciation $500 $500 $500
− Capital expense $(500) $(500) $(500)
Change in net working capital 0 0 0
Free cash flow ___

This note was prepared by Robert F. Bruner. It was written as a basis for class discussion rather than to illustrate
effective or ineffective handling of an administrative situation. Copyright © 1989 by the University of Virginia Darden
School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a
spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or
otherwise—without the permission of the Darden School Foundation. Rev. 12/05.
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Why does the value of assets change? Where, specifically, do those changes occur?
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.
0% Debt/ 25% Debt/ 50% Debt/
100% Equity 75% Equity 50% Equity

Cash flow to creditors:

Interest 0 $125 $250
Pretax cost of debt .05 .05 .05
Value of debt:
(Interest/kd) ___
Cash flow to shareholders:
EBIT $1,485 $1,485 $1,485
− Interest 0 $(125) $(250)
Pretax profit ___
Taxes (@ 34%) ___
Net income ___
+ Depreciation $500 $500 $500
− Capital expense $(500) $(500) $(500)
+ Change in net working capital 0 0 0
− Debt amortization 0 0 0
Residual cash flow (RCF) ___
Cost of equity ___
Value of equity (RCF/ke) ___
Value of equity plus value of debt ___
As the firm levers up, how does the increase in value get apportioned between the creditors
and the shareholders?
3. In the preceding problem, we divided the value of all the assets between two classes of
investors: creditors 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.
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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 expense $(500) $(500) $(500)
+ Change in net working capital 0 0 0
Free cash flow (FCF) $980 $980 $980
Unlevered beta .8 .8 .8
Risk-free rate .05 .05 .05
Market premium .06 .06 .06
Unlevered WACC ___
Value of pure business flows:
(FCF/unlevered WACC) ___
Financing cash flows
Interest ___
Tax reduction ___
Pretax cost of debt .05 .05 .05
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 shields1

^ ^ ^
Problem 1 Problem 2 Problem 3
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

1
Debt tax shields can be valued by discounting the future annual tax savings at the pretax cost of debt. For debt,
that is assumed to be outstanding in perpetuity, the tax savings is the tax rate, t, times the interest payment, k × D.
The present value of this perpetual savings is tkD/k = tD.
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clearly not investing the proceeds from the loans into 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
unknowns—share price and the change in the number of shares:

Share price = Market value of equity_______

Original shares − Repurchased shares

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

Share price = Original market value of equity + Value of financing effect

Number 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/ 50% Debt/
100% Equity 75% Equity 50% Equity

Total market value of equity ___

Cash paid out ___
Number of original shares 1,000 1,000 1,000
Total value per share ___
5. In this set of problems, is leverage good for shareholders? Why? Is levering/unlevering the
firm something that shareholders can do for themselves? In what sense should shareholders
pay a premium for shares of levered companies?
6. From a macroeconomic point of view, is society better off if firms use more than zero debt
(up to some prudent limit)?
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 worksheet. 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 a share; subsequently, the offer was
raised to $56 and then finally to $61 a share. The Koppers board 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% and that the
aggregate amount of debt will remain constant in perpetuity. Thus, Koppers will take on
additional debt of $l,565,686,000 (that is, $1,738,095,000 minus $172,409,000). Also
assume that the proceeds of the loan would be paid as an extraordinary dividend to
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shareholders. Exhibit 1 presents Koppers’ book- and market-value balance sheets, assuming
the capital structure before recapitalization. Please complete the worksheet for the
recapitalization alternative.
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Exhibit 1
AN INTRODUCTION TO DEBT POLICY AND VALUE
Koppers Company, Inc.
(values in thousands)

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
Present value (PV) debt tax shield 58,619
Total assets $1,889,153

Long-term debt $172,409

Deferred taxes, etc. 0
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 0
Value of shares $1,701,744
Total 1,701,744
Total per share $ 60.50