Case 26

An lntroduction to Debt

Many f-rs determine how much debt a í h takes on. Chief among them ought to be the effect of the debt on the vdue of tbe fínn. Does borrowing create value? if so, for whom? If not, then why do so many exemtives concem themselves wiih leverage?

If leverage affects value, then it should cause changes in either the dieunt rate of the fmn (Le., its weighted-average cost of capital) or the cash flows of the fírm.

1, Please fiil in the following:

Book value of debt Book vaiue of equity Market value of debt Market vaiue of qu i ty h t & x eose of debt Afb-tax cost of &bt Market value weights of:

Debt EsuitY

Unlevered beta Risk-íree rate Market premium Cost of equity Weighted-average cost of capital EBIT - mes (e 34%) EBIAT + Depmciation - Capital expenditures Free cash flow Value of assets (FCFNACC)

Why does the value of sissets chane? Where,'specifically, do the changas occur? 2 In ñmnce, as in accounting, the two sides of tbe balance sheet must be equal. In the

previws problem, we valued the asset side of the b b c e sheet. To value the other side, we must value the debt and the equity, and then add them together.

Cash flow to creditors: Tnterest

Pretax cost of debt Value of debt:

(m/rdl Cash flow m sharehoIders:

EBrr - hterest Prehx profit Taxes (@ 34%) Net incorne + Depreciation - Qpitai expenditures - Debt morbation

Residual cash flow Cost of equis Vaiue of equity (CF/r=) Value of equity plus value of &bt

As the fm leven up, how does the iacmase in value get +med betwm d t o r s and sha~eholders? 3. In the preceding problem, we divided the value of al1 the assets between two classes of i n v e s t o d t o r s and shareholders. This process teik us where the change in vaIue is going, but it s W iittle light on where ihe change is comingfim Let's divide the free cash flows of the ñrm into p w bupimss Puws and cash flows resuiting fmm finuncing t$ects. Now, an axiom in ñnance is that y w s h d d discount cash flows at a rate consis- tent with the risk of those cash flows. Pme business flows should be dixounted at the devered w t of equity (Le., the cost of capital for the unlevered h). Financing flows shouid be discounted at the rate of renim required by the kviders of debt

was prepartd by h h u r Robert F. Brrurer. 'Ibis &se was written as a bass for das discus- ~ ~ t f i a n t o i l l ~ ~ ~ t o r ~ v e ~ a f a n a d m i n i W ~ e s i ~ m ~ g h t 8 1989by & U n i d @ of Virgiiiia Dardai School h u d h n , Charioüewik VA. AU rights reserved No part of chis pub- IdwIiwr may k r r p u S!O& in a retrteiaal system, used in a spmadsheet, or tmmm'tted in any fom or by uny -, m ~ h a n k 4 p- m o r d b or oihtwipe-witbut the p e m * s ~ w n of the Darden R n a t h t h k r h p i r i e s , pktw s d un e - d to ~ e ~ s @ v i r g i n i a e d u . Revised 1 1197. Vwsion 1 -3.

PIJE business cash flows: EBrr Ttuces (@ 34%) EBIAT +Depreciatiun - Capital expeaditures cash flow

Udevered beta M-free me M&et premium Unlevered WACC Vdue of pure business flows:

(CFKínleversd WACC) Firmdg eash flom

htereai Tax reduction

PrieCaxcostof&bt Vdue of fínancing e f h t (Tax reductiodpmtax cost of

Total value (sum of vdues of Pure business flows and ñnancing effects)

The first three prob1ems illustrate one of the most importmt thewies in finance. This the- ory, &velo@ by two pmfesms, Fmco Modigliani and Merton Miller, revolutionized the way we think. about capital-structure policies. The M&M thmy says: Vdue of - Vdue of Value of Vdue of Value of + - - assets - debt W~Y unlevered &m + de@ tax shields'

A A A

Problem 2 Problem 3 4 What reraains to ?x seen however, is whether shareho1d.s are M e r or w m e off

with more Ieverage. h b l e m 2 does not teU us, because there we ~omputeá total vdue of equity, and shareholders care about value per s h n . Orduiarily, .total value will be a g d proxy for whai is happening to the price pr share, but in h e case of a relevering firm, that may not be true. irnplicitly we assumed that, as our firm in problems 1-3 levered up, it was repurchasing stock on rhe open market Iyou will note that EBIT did not change, so man- agemnt was clearly not invesling the pmcecds from the loans in ash-gencIsting assets).

' k b t tax shields cm be vduad by djiscounting the fume mnual tax savings at the pretax mst of dcbt. For debt that is sssumod ta be outstanding in perpetuity, the tax savings is the tax mte, t, times the interest paymcflt, r *B. 'Zhc present vdue of this perpetua1 savings is tr31r = RB.

W e held EBlT constant so that we could S& c1early the effecl of hac ia1 changes wia- out getting them rnixed up in the effects of investments. The poht is that, as the fimi &- rows and repurchases shares, the total value of equity may decline, but the price per share may rise.

Now, solving for the price per shmrre may seem impossible, because we are deaiing with two unknowns-share price and change in the nurnbec of shares:

Share price = Total market value of equity (Original shares - R e p u r c W 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 al1 the new &M is qual to the cash paid to repurchase shares. Piease compIete the foliowhg table:

Total market value of equity Cash paid out Number of original shares Total value per share

5. Tn this set of problems, is leverage good for shareholders? Why? 1s leveringhnlever- ing the firm something shmholders can do for themselves? in what sense should share- holders pay a premium for shares of levered campanies?

6, From a macroeconomic point of view, is society ktter off if firms use more than zero debt (up to some prudent limit)?

7. As a way of iüustxating the usefulness of the M&M theory and consolidating your grasp of the mechstnics, consider the following case and complete the work sheec. On March 3, 1988, Beazer PLC, a British construction company, and Shearson Lehman Hutton, Inc. (an investment banking fm), commenced a hostile tender offer to purchase al1 the outstanding stock of Koppers Cornpany, Inc., a p d u c e r of constnictian materials, chemicals, and building products. Otiginally the raiders offered $45 per share; subse- quently the offer was raised to $56, and then finally $6 2 per share. The Koppers board gen- eraiiy asserted that the offers were inadequate and its management was reviewing the pos- sibility of a major recapitalization. To test the vahation effscts of the recapitaluation altemative, assume that Koppers could

borrow a maximurn of $1,738,095,000 at a pretax cost of debt of 10.5 percent and that the aggregate amount of debt wiil remain constant in perpetuity. Thus, Koppers will take on addi- tiond debt of $1,565,686,000 (i-e., $1,738,095,000 minus $172,409,000, the pre-existing long- tem debt). Also assume that the praceeds of the loan would be paid as an extraordinary div- idend to shareholders. Exhibit 1 pcesents Koppers's book- and market-value balance sheets assurning the capital stnicture before mapitaibtion. Please complete the worksheet for the

* recapitalization alternative.

EXJIIBIT 1 Koppers -y, hc. (valuts are in thwsmds)

Book-value balance sheets Net working capital Fmed assecs

'Ibtal asse#

Lwg- debt Deferred taxes, etc. freferred stock Comrmin equity

Total capitd M a r k e b ~ ~ ~ Net working capital Fied wets PV debt tax sbield

Total assets Long-term debt Deferred taxes, e&. P r e f d stock commwi equity

Total capital

After