1. 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.

Please fill in the following:

25% 50%
0% Debt/ Debt/ Debt/
100% 75% 50%
Equity Equity Equity
Book Value of Debt $0 $2,500 $5,000
Book Value of Equity $10,000 $7,500 $5,000

Market Value of Debt $0 $2,500 $5,000

Market Value of Equity $10,000 $8,350 $6,700

Pretax Cost of Debt 5.0% 5.0% 5.0%

After-Tax Cost of Debt 3.3% 3.3% 3.3%

Market Value Weights of:

Debt 0 0.23   0.43
Equity 1.0 0.77   0.57
Levered Beta 0.00   0.9581   1.1940
Unlevered Beta 0.80 0.80 0.80
Risk-Free Rate 5.0% 5.0% 5.0%
Market Premium 6.0% 6.0% 6.0%
Cost of Equity 0.098   0.10749   0.12164
Weighted-Average Cost of
Capital 0.098   0.09032   0.08376
EBIT $1,485 $1,485 $1,485
Taxes (@ 34%) $504.90   $504.90   $504.90
EBIAT $980.10   $980.10   $980.10
+ Depreciation $500 $500 $500
˗ Capital Exp. ($500) ($500) ($500)
Change in net working capital 0 0 0
Free Cash Flow $980.10   $980.10   $980.10
$10,851.1 $11,701.
Value of Assets (FCF/WACC) $10,001.02   1   19

Why does the value of assets change? Where, specifically, do those changes occur?
The value of assets changes because the debt is increasing. It occurs where the market
value of debt increases.

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/ 0% Debt/ 0% Debt/
100% 75% 50%
Equity Equity Equity

Cash Flow to Creditors:

Interest $0 $125 $250
Pretax Cost of Debt 5.0% 5.0% 5.0%
Value of Debt:
(Interest/kd) $0 $2,500   $5,000

Cash Flow to Shareholders:

EBIT $1,485 $1,485 $1,485
Interest $0 ($125) ($250)
Pretax Profit   $1,485   $1,360   $1,235
Taxes (@ 34%)   $504.90   $462.40   $419.90
Net Income   $980.10   $897.60   $815.10
+ Depreciation $500 $500 $500
˗ Capital Exp. ($500) ($500) ($500)
+ Change in NWC $0 $0 $0
˗ Debt Amortiz. $0 $0 $0
Residual Cash Flow (RCF)   $980.10   $897.60   $815.10
Cost of Equity   0.098   0.10749   0.12164
Value of Equity (RCF/re)   $10,001.02   $8,350.93   $6,700.82
Value of Equity plus Value of
Debt   $10,001.02   $10,850.93   $11,700.82

As the firm levers up, how does the increase in value get apportioned between creditors
and shareholders?
The increase in value occurs is because of the creditors’ debt. As a result, creditors would
get more value apportioned increase than shareholders would.
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/
100% 25% Debt/ 50% Debt/
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
+Depreciation $500 $500 $500
-Capital Exp. ($500) ($500) ($500)
+Change in NWC $0 $0 $0
Free Cash Flow (FCF) $980 $980 $980

Unlevered Beta 0.80 0.80 0.80

Risk-Free Rate 5.0% 5.0% 5.0%
Market Premium 6.0% 6.0% 6.0%
Cost of Equity 0.098 0.098 0.098
Unlevered WACC   0.098   0.098   0.098

Value of Pure Business Flows:

(FCF/Unlevered WACC)   $10,000.00   $10,000.00   $10,000.00

Financing Cash Flows:

Interest   0   $125.00   $250.00
Tax Reduction   0   $42.50   $85.00

Pretax Cost of Debt 5.0% 5.0% 5.0%

Value of Financing Effect:

(Tax Reduction/Pretax Cost of Debt)   $0.00   $850.00   $1,700.00

Total Value (Sum of Values of Pure

Business Flows and Financing Effects)   $10,000.00   $10,850.00   $11,700.00

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.

Original market value of equity +Value of financing effect

Share price=
Number of original shares

0% Debt/ 25% Debt/ 50% Debt/

100% 75% 50%
Equity Equity Equity

Total Market Value of Equity   $10,001.02   $8,350.93   $6,700.82

Cash Paid Out   $0   $2,500   $5,000
# Original Shares 1,000 1,000 1,000
Total Value Per Share   $10.00   $10.85   $11.70

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?

In this case, leverage is good for shareholders. It is good because it increases the
company’s assets’ value. And also, because of the potential of a higher return on
investment, despite of more risk involved. Consequently, because of the value increasing
that leverage brings, shareholders should pay shares premium 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)?

Society is better off because the use of more than zero debt up to some prudent level
because it lets banks to lend money. If bank did not lend money, it would end up with
excess cash which leads to the fall of interest rates on bank deposits. Low interest rates
would lead to inflation which is not advantageous to the macroeconomic environment.
As a consequence, the value of money would decrease.

7. 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.

Before After
Recapitalization Recapitalization

Book Value Balance Sheets

Net working capital $212,453 $1,778,139.00
Fixed assets $601,446 $601,446.00
Total assets $813,899 $2,379,585.00

Long-term debt $172,409 $1,738,095.00

Deferred taxes, etc. $195,616 $195,616.00
Preferred stock $15,000 $15,000.00
Common equity $430,874 $430,874
Total capital $813,899 $2,379,585.00

Market-Value Balance Sheets

Net working capital $212,453 $1,778,139.00
Fixed assets $1,618,081 $1,618,081.00
PV debt tax shield $58,619 $590,952.30
Total assets $1,889,153 $3,987,172.00

Long term debt $172,409 $1,738,095

Deferred taxes, etc. $0 $0
Preferred stock $15,000 $15,000
Common equity $1,701,744 $2,234,077.30
Total capital $1,889,153 $3,987,172.30

Number of shares $28,128 $28,128

Price per share $60.50 $79.43

Value to Public Shareholders

Cash received $0 $1,565,686
Value of shares $1,701,744 $668,391.30
Total $1,701,744 $2,234,077.30
Total per share $60.50 $79.43