How does debt create value?

● Debt costs are cheaper than equity costs. So the value of equity increases
because more low-cost capital is used to create the same return.
● The cost of debt, interest, can be deducted from taxes so that the value is
increased compared to direct dividends.
● Debt create financial leverage. The use of financial leverage to control a greater
amount of assets (by borrowing money) will cause the returns on the owner's
cash investment to be amplified. That is, with financial leverage:
- an increase in the value of the assets will result in a larger gain on the
owner's cash, when the loan interest rate is less than the rate of increase in
the asset's value
- a decrease in the value of the assets will result in a larger loss on the
owner's cash
Problem 1 - Value of Assets
Why does the value assets change?
Because the leverage change the
WACC. The cost of equity is typically
higher than the cost of debt, so increasing
debt financing usually reduce WACC &
increase company value.

Where, specifically, do those

changes occur?

The changes occur on the proportion

between debt & equity
Problem 2 - Value of Debt & Equity
As the firm levers up, how does the
increase in value get apportioned
between the creditors and the
shareholders?
The increase of value apportioned by
the market value weight of debt to
creditors and market value weight of
equity to shareholders
Problem 3 - Business Flows and Financing Effects
Problem 4 - Business Flows and Financing
Effects
We can calculate share price with equation

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

Number of original shares

Cash paid out = total value in

problem 3

Total value/share = cash paid out/

number of origial share
Problem 5 - Is Levered good for shareholders?

Is levered good for shareholders? Why?

Yes, as seen as problem 4 adding debt increase the total value per share, which will lead to
increase value for shareholders. WACC tends to be lower for more leveraged companies as long
as they are able to service the debt. A lower WACC increases the calculated present value of
anticipated future cash flow, which is projected to increase the share price.

Is levering/unlevering the firm something that shareholders can do for

themselves?
Whether to leverage the firm or not is normally a management/executive
function instead of a shareholder function
In what sense should shareholders pay a premium for shares of levered companies?

When a company is levered, the WACC is lower and company can maximize
profits and maximize shareholders wealth, but the risk of the firm also increases.
Hence it is reasonable for the shareholder to pay a premium.
Problem 6 - Macroeconomic Point of View

From a macroeconomic point of view, is society better off if firms use

more than zero debt (up to some prudent limit)?
Yes, for some reason:

● Debt can fuel growth of company by maximizing it’s profit (resource allocation)
● Tax deduction allows business to use the money saved to grow the business.
● Debt maintain company ownership. Management has complete control over the
decisions made on behalf of the company.
● Giving managers a need to stay controlled with the free cash flow
● In general debt provide less risk than equity
Problem 7 - Recapitalization Alternatives, Koppers
Company, Inc.

● Beazer PLC & Searson Lehman Hurton commenced a hostile tender offer to
purchase all the outstanding stock of Koppers Company, Inc.
● Raiders offered $45 a share, raised to $56 and then finally reaching $61 a share
● Assume that Koppers could borrow a maximum of $1,738,095,000 at a pretax cost
of debt of 10.5%
● Koppers will take on additional debt of $l,565,686,000 (that is, $1,738,095,000
minus $172,409,000).
Problem 7 - Recapitalization, Koppers Company, Inc.
Problem 7 - Recapitalization, Koppers Company, Inc.