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 25% debt 50% debt

100% equity 75% equity 50% equity
Book Value of debt $ - $ 2.500 $ 5.000
Book value og 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 0,0700 0,0700 0,0700
After tax cost of debt 0,0462 0,0462 0,0462
Market value weights of:
Debt 0% 23,04% 42,74%
Equity 100% 76,96% 57,26%
Unlevered beta 0,80 0,80 0,80
Risk-free rate 0,07 0,07 0,07
Market premium 0,086 0,086 0,086
Cost of equity 13,88% 15,24% 17,27%
WACC 13,88% 12,79% 11,86%
EBIT $ 2.103 $ 2.103 $ 2.103
(-) Taxex (34%) $ 715,0200 $ 715,0200 $ 715,0200
EBIAT $ 1.387,9800 $ 1.387,9800 $ 1.387,9800
(+) Depreciation $ 500 $ 500 $ 500
(-) Capital expeditures -$ 500 -$ 500 -$ 500
FCF $ 1.387,9800 $ 1.387,9800 $ 1.387,9800
Value of assets (FCF/WACC) $ 9.999,8559 $ 10.849,8437 $ 11.699,8314

Extras:
Tax 34%
Levered beta 0,098 0,958 1,194

Why does the value of assets change? Where, specifically, do the 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 $ - $ 175 $ 350
Pretax cost of debt 0,07 0,07 0,07
Value of debt $ - $ 2.500 $ 5.000
Cash flow to shareholders:
EBIT $ 2.103 $ 2.103 $ 2.103
(-) Interest $ - -$ 175 -$ 350
Pretax profit $ 2.103 $ 1.928 $ 1.753
Taxes (34%) $ 715,02 $ 655,52 $ 596,02
Net income $ 1.387,98 $ 1.272,48 $ 1.156,98
(+) Depreciation $ 500 $ 500 $ 500
-$
(-) Capital expenditures 500 -$ 500 -$ 500
(-) Debt amortization $ - $ - $ -
Residual cash flow $ 1.388 $ 1.272 $ 1.157
Cost of equity 13,88% 15,24% 17,27%
Value of equity $ 9.999,86 $ 8.349,87 $ 6.699,88
Value of equity plus value of debt $ 9.999,86 $ 10.849,87 $ 11.699,88

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

**If the firms borrows within the weight of debt, then it can create value for shareholders

**The increase in value gets apportioned between creditors and shareholders by the
market value weight of debt to creditors, and market value weight of equity to 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.

0% debt 25% debt 50% debt

100% equity 75% equity 50% equity
Pure business cash flows:
EBIT $ 2.103 $ 2.103 $ 2.103
Taxes (34%) -$ 715 -$ 715 -$ 715
EBIAT $ 1.388 $ 1.388 $ 1.388
$
(+) Depreciation $ 500 500 $ 500
 (-) Capital expenditures -$ 500 -$ 500 -$ 500
Cash Flow $ 1.388 $ 1.388 $ 1.388
Unlevered beta 0,80 0,80 0,80
Risk free rate 0,07 0,07 0,07
Market premium 0,086 0,086 0,086
Unlevered WACC 0,1388 0,1388 0,1388
Value of pure business flows:
CF/ Unlevered WACC $ 10.000 $ 10.000 $ 10.000
Financing cash flows:
$
Interest $ - 175 $ 350
$
Tax reduction $ - 60 $ 119
Pretax cost of debt 0,07 0,07 0,07
$
Value of financing effect $ - 850 $ 1.700
Total value $ 10.000 $ 10.850 $ 11.700

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 Value of Value of Value of debt

assets = of debt + equity = unlevered firm + tax shields
^ ^ ^
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 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 unknowns—share price and change in the number of shares:

Share price = Total 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 = Total market value of equity + Cash paid out

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 $ 10.000 $ 8.350 $ 6.700
Cash paid out $ - $ 2.500 $ 5.000
Number of original shares 1000 1000 1000
Total value per share $ 10,00 $ 10,85 $ 11,70

5. 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 $1.565.686.000 (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.

Before After
Recapitalization Recapitalization
Nueva deuda $ 1.565.686
Book-Value Balance Sheets:
$
Net working capital 212.453 $ 212.453
$
Fixed assets 601.446 $ 601.446
Total assets $ $ 813.899
 813.899

$
Long-term debt 172.409 $ 1.738.095
$
Deferred taxes, etc.. 195.616 $ 195.616
$
Preferred stock 15.000 $ 15.000
$
Common equity 430.874 -$ 1.134.812
$
Total capital 813.899 $ 813.899

Market-Value Balance Sheets:

$
Net working capital 212.453 $ 212.453
$
Fixed assets 1.618.081 $ 1.618.082
$
PV debt tax shield 58.619 $ 590.952
$
Total assets 1.889.153 $ 2.421.487

$
Long-term debt 172.409 $ 1.738.095
Deferred taxes, etc.. $ - $ -
$
Preferred stock 15.000 $ 15.000
$
Common equity 1.701.744 $ 668.392
$
Total capital 1.889.153 $ 2.421.487

Number of shares 28.128 28.128

$
Price per share 60,50 $ 23,76

Value to Public Shareholders

Cash received $ - $ 1.565.686
$
Value of shares 1.701.744 $ 668.392
$
Total 1.701.744 $ 2.234.078
$
Total per share 60,50 $ 79,43