31.An Introduction to Debt

31 CASE 425 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 –– $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%) 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@dardenbusinesspublishing.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 mean—electronic, mechanical, photocopying, recording, or otherwis—without the permission of the Darden School Foundation. Rev. 06/12. (Continued) bru6171X_case31_423-430.qxd 12/8/12 12:20 PM Page 425 426 Part Six Management of the Corporate Capital Structure (Continued) 0% Debt/ 25% Debt/ 50% Debt/ 100% Equity 75% Equity 50% Equity EBIAT ϩ Depreciation $500 $500 $500 Ϫ Capital exp. ($500) ($500) ($500) ϩ Change in net working capital –– –– –– Free Cash Flow Value of Assets (FCF/WACC) 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 –– $125 $250 Pretax cost of debt 5.0% 5.0% 5.0% Value of debt: (Int/K d ) Cash flow to shareholders: EBIT $1,485 $1,485 $1,485 Interest –– $125 $250 Pretax profit Taxes (@ 34%) Net income ϩ Depreciation $500 $500 $500 Ϫ Capital exp. ($500) ($500) ($500) ϩ Change in net working capital –– –– –– Ϫ Debt amortization –– –– –– Residual cash flow Cost of equity Value of equity (RCF/K e ) 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? bru6171X_case31_423-430.qxd 12/8/12 12:20 PM Page 426 Case 31 An Introduction to Debt Policy and Value 427 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 $1,485 $1,485 $1,485 Taxes (@ 34%) $505 $505 $505 EBIAT $980 $980 $980 ϩ Depreciation $500 $500 $500 Ϫ Capital exp. ($500) ($500) ($500) ϩ 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) 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. bru6171X_case31_423-430.qxd 12/8/12 5:09 PM Page 427 428 Part Six Management of the Corporate Capital Structure The M&M theory says: 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 pro- ceeds 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: But by rewriting the equation, we can put it in a form that can be solved: 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 # Original Shares 1,000 1,000 1,000 Total Value Per Share Share price ϭ Original market value of equity ϩ Value of financing effect Number of original shares Share price ϭ Market value of equity Original shares Ϫ Repurchased shares Value of Value of Value of Value of Value of assets ϭ debt ϩ equity ϭ unlevered ϩ debt tax firm shields 1 ^^ ^ Problem 1 Problem 2 Problem 3 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 ϫ D. The present value of this perpetual savings is tkD/k ϭ tD. bru6171X_case31_423-430.qxd 12/8/12 12:20 PM Page 428 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 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. Case 31 An Introduction to Debt Policy and Value 429 bru6171X_case31_423-430.qxd 12/8/12 12:20 PM Page 429 430 Part Six Management of the Corporate Capital Structure EXHIBIT 1 | 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 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 bru6171X_case31_423-430.qxd 12/8/12 12:20 PM Page 430 . 31 CASE 425 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. value get apportioned between the creditors and the shareholders? bru6171X_case31_423-430.qxd 12/8/12 12:20 PM Page 426 Case 31 An Introduction to Debt Policy and Value 427 3. In the preceding problem,. alternative. Case 31 An Introduction to Debt Policy and Value 429 bru6171X_case31_423-430.qxd 12/8/12 12:20 PM Page 429 430 Part Six Management of the Corporate Capital Structure EXHIBIT 1 | Koppers Company,