Debt Policy and Value

EMBA 8500 #1 Book value of debt Book value of equity Market value of debt Market value of equity Pretax cost of debt After Tax cost of debt rd Market value weights of: Wd Debt We Equity bL Levered beta Rf Risk-free Rate Market Premium RM Ke Cost of equity WACC EBIT – Taxes (34%) EBIAT + Depreciation – Capital expense Change in Net Working Capital Free Cash Flow Value of Assets ( FCF/WACC) CASE # 31 0% Debt 100% Equity $ $ 20,000 $ $ 20,000 7. 0% 4. 62% $ 34% $ $ $ $ $ $ 0 1 0. 8 7% 8. 6% 13. 88% 13. 88% 4,206. 00 1,430. 04 2,775. 96 1,000. 00 (1,000. 00) 0 2,775. 96 19,999. 1 25% Debt 75% Equity $ 5,000 $ 15,000 $ 5,000 $ 16,700 7. 0% 4. 62% 12/2/2012 50% Debt 1) As the firm becomes more leveraged the WACC will change because debtholders have a 50% Equity fixed claim on cash which increases the risk for stockholders. This can cause the stock to go up $ 10,000 and firms can reduce the taxes paid, thereby freeing up more cash. Debt also increases the risk $ 10,000 of bank ruptcy. $ 10,000 $ 13,400 (Debt * Tax Rate) + BV Equity 7. 0% 4. 62% (Pretax * (1-Tax Rate)) 23. 0% 42. 7% 77. 0% 57. 3% 0. 96 1. 19 7% 7% 8. 6% 8. 6% 15. 24% 17. 27% 12. 79% 11. 6% $ 4,206. 00 $ 4,206. 00 $ 1,430. 04 $ 1,430. 04 $ 2,775. 96 $ 2,775. 96 $ 1,000. 00 $ 1,000. 00 $ (1,000. 00) $ (1,000. 00) 0 0 $ 2,775. 96 $ 2,775. 96 $ 21,699. 69 $ 23,399. 66 Added Tax Shield increase value VL = VU + TD MV Debt / (MV Debt + MV Equity) MV Equity / (MV Debt + MV Equity) 0. 8 is the b u b L = b u [1+(1-T) * D/E HAMADA D/E Ratio 29. 94% 74. 63% Ke = Rf + (b L * RM) CAPM WACC = (Wd * rd) + (We * re) EBIT * Tax Rate EBIT – Tax amount V = FCF/WACC M3DISK – Maryann Albert, Mike Arendosh, Mark Jarboe, Dan Pool, Ivo Hegelbach, Sean McPherson, Krista Massell 1