Muhammad Nabil Ezra

29118095

An introduction to debt policy and value

Problem 1: Value of Assets

0% Debt/ 25% Debt/ 50% Debt/
100% Equity 75% Equity 50% Equity
Book Value of Debt - $ 2,500.00 $ 5,000.00
Book Value of Equity $ 10,000.00 $ 7,500.00 $ 5,000.00

Market Value of Debt - $ 2,500.00 $ 5,000.00

Market Value of Equity $ 10,000.00 $ 8,350.00 $ 6,700.00

Pretax Cost of Debt 0.05 0.05 0.05

After-Tax Cost of Debt 0.0330 0.0330 0.0330

Market Value Weights of

Debt 0% 23.04% 42.74%
Equity 100% 76.96% 57.26%
Unlevered Beta 0.80 0.80 0.80
Levered Beta 0.80 0.96 1.19
Risk-Free Rate 0.05 0.05 0.05
Market Premium 0.060 0.060 0.060
Cost of Equity 0.098 0.107 0.122
Cost of Debt 0.03 0.03 0.03
Weighted-Average Cost of Capital 0.10 0.09 0.08
EBIT $ 1,485.00 $ 1,485.00 $ 1,485.00
Taxes (@ 34%) $ 504.90 $ 504.90 $ 504.90
EBIAT $ 980.10 $ 980.10 $ 980.10
+ Depreciation $ 500.00 $ 500.00 $ 500.00
- Capital exp. $ (500.00) $ (500.00) $ (500.00)
+ Change in net working capital - - -
Free Cash Flow $ 980.10 $ 980.10 $ 980.10

Value of Assets (FCF/WACC) $ 10,001.02 $ 10,851.11 $ 11,701.19

Problem 2: Value of Equity and Debt
0% Debt/ 25% Debt/ 50% Debt/
100% Equity 75% Equity 50% Equity

Cash flow to creditors:

Interest $ - $ 125.00 $ 250.00
Pretax cost of debt 0.05 0.05 0.05
Value of debt: (CF/rd) $ - $ 2,500.00 $ 5,000.00

Cash flow to shareholders:

EBIT $ 1,485.00 $ 1,485.00 $ 1,485.00
- Interest - $125 $250
Pretax profit $ 1,485.00 $ 1,360.00 $ 1,235.00
Taxes (@ 34%) $ 504.90 $ 462.40 $ 419.90
Net income $ 980.10 $ 897.60 $ 815.10
+ Depreciation $ 500.00 $ 500.00 $ 500.00
- Capital exp. $ (500.00) $ (500.00) $ (500.00)
+ Change in net working capital - - -
- Debt amortization - - -
Residual cash flow $ 980.10 $ 897.60 $ 815.10

Cost of equity 0.0980 0.1075 0.1216

Value of equity (CF/re) $ 10,001.02 $ 8,350.93 $ 6,700.82

Value of equity plus value of debt $ 10,001.02 $ 10,850.93 $ 11,700.82

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 $ - $ - $ -
Cash Flow $ 980 $ 980 $ 980

Unlevered Beta 0.8 0.8 0.8

Risk-Free Rate 0.05 0.05 0.05
Market Premium 0.060 0.060 0.060
Unlevered WACC 9.80% 9.80% 9.80%

Value of Pure Business Flows:

(FCF/Unlevered WACC) $ 10,001.02 $ 10,001.02 $ 10,001.02

Financing Cash Flows

Interest $ - $ 175.00 $ 350.00
Tax Reduction $ - $ 59.50 $ 119.00

Pretax Cost of Debt 0.05 0.05 0.05

Value of Financing Effect:

(Tax Reduction/Pretax Cost of Debt) $ - $ 1,190.00 $ 2,380.00

Total Value (Sum of Values of

Pure Business Flows and Financing Effects) $ 10,001.02 $ 11,191.02 $ 12,381.02
 0% Debt/ 25% Debt/ 50% Debt/
100% Equity 75% Equity 50% Equity

Value of Asset $ 10,001.02 $ 10,851.11 $ 11,701.19

Cash Paid Out $ - $ 2,500.00 $ 5,000.00
Total Market Value of Equity $ 10,001.02 $ 8,351.11 $ 6,701.19
Number of Original Shares 1,000 1,000 1,000
Total Value Per Share $ 10.00 $ 10.85 $ 11.70
 Is leverage good for shareholders?

Yes, because as shown in question4, total value per share

increased which would lead to an increase in value for
shareholders. Increase the shareholders' return on investment

Is levering/unlevering the firm something that shareholders

can do for themselves?
No, it is the hands of the firm and the executives

In what sense should shareholders pay a premium for shares

of levered companies?
In case like this where debt increases the value of the shares
 From a macroeconomic point of view, is society better off if firms use more than
zero debt (up to some prudent limit)?
Yes

Allows investors to provide extra funds and earn interest from it, debt is generally
less risky than equity investing, and help resources allocation as well giving
managers a need to stay controlled with the free cash flows
 Koppers Company, Inc.
Before After
Recapitalization Recapitalization

Book Value Balance Sheets

Net working capital $ 212,453.00 $ 1,778,139.00
Fixed assets $ 601,446.00 $ 601,446.00
Total assets $ 813,899.00 $ 2,379,585.00

Additional debt $ 1,565,686.00

Long-term debt $ 172,409.00 $ 1,738,095.00
Deferred taxes, etc. $ 195,616.00 $ 195,616.00
Preferred stock $ 15,000.00 $ 15,000.00
Common equity $ 430,874.00 $ 430,874.00
Total capital $ 813,899.00 $ 2,379,585.00

Market-Value Balance Sheets

Net working capital $ 212,453.00 $ 212,453.00
Fixed assets $ 1,618,081.00 $ 1,618,081.00
PV debt tax shield $ 58,619.00 $ 590,952.30
Total assets $ 1,889,153.00 $ 2,421,486.30

Long term debt $ 172,409.00 $ 1,738,095.00

Deferred taxes, etc. $ - $ -
Preferred stock $ 15,000.00 $ 15,000.00
Common equity $ 1,701,744.00 $ 668,391.30
Total capital $ 1,889,153.00 $ 2,421,486.30

Number of shares $ 28,128.00 $ 28,128.00

Price per share $ 60.50 $ 23.76

Value to Public Shareholders

Cash received $ - $ 1,565,686.00
Value of shares $ 1,701,744.00 $ 668,391.30
Total $ 1,701,744.00 $ 2,234,077.30
Total per share $ 60.50 $ 79.43