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An Introduction to Debt Policy and Value

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Yao Xu

on 17 November 2014

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Transcript of An Introduction to Debt Policy and Value

An Introduction to Debt Policy and Value
problem 1
Value of Assets
problem 2
Value of Debt & equity
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
Is leverage good for shareholders?
Is levering/ unlevering the firm somethign that shareholders can do for themselves?
In what sense should shareholders pay a premium for shares of levered companies?
Yes, because as shown in Q4, total value per share increases which would lead to an increase in value for shareholders. increase the shareholders' return on investment
No,It is in the hands of the firm and the executives
In case like this where debt increases the value of the shares
From a macroeconomic point of view, is society better off if firms use more than zero debt(up to some prudent limit)?
Yes
Allows investors to provide extra funds and earn interest from it
Debt is generally less risky than equity investing
Help resources allocation as well as giving managers a need to stay controlled with the free cash flows
Beazer PLC and Shearson Lehman Hutton,Inc commenced a hostile tender offer to purchase all the outstanding stock of Koppers Company, Inc
Raiders offered $45 a share, raised to $56 and then finally to $61 a share
Borrow a maximum of $1,738,095,000 at a pretax cost of debt of 10.5%

New debt:1,565,686,000
Recapitalization alternative
Yao Xu
Luyao Zhou
Presented By:
Jacob Caporali
Book value balance sheet

Market value balance sheet
Assuming the capital structure before recapitalization
(value in thousands)
Value of assets=Value fo debt +Value of equity
Assuming present value of the debt tax shield =0.34 times debt balance
31 percent increase in value
The M&M Theory
Developed in 1958 by Modigliani & Miller
One of the most important theories in finance
Why does the value of assets change?

The value of assets
change because the
leverage changes the
WACC.

Where specifically do the changes occur?
As the firm levers up, how does the increase in value get apportioned between creditors and shareholders?

Does borrowing create value? If so, for whom?

It depends; a company is able to create value if it borrows within the weight of the debt it takes on. This value is created for the shareholders. If a firm borrows more then the optimal amount of debt, then it could potentially destroy the shareholder's value.

Problem three
Value of unlevered firm and debt tax shields
Unlevered WACC = Market risk premium * Unlevered beta + Risk-free rate
Value of pure business
= Cash flow / Unlevered WACC
Tax reduction = Interest
* Tax rate (34%)
Value of financing effect
= Tax reduction / Pretax cost of debt
Total value = Value of financing effect
+ Value of pure business
Problem four
we can find interest in question 2
*
we can calculate share price with the following rewritten equation:
Share price = Market value of equity / (Original shares – Repurchased shares)

= (Original market value of equity + Value of financing effect) / Number of original shares
Cash paid out = Total value in question 3
Total value per shares = cash paid out / number of original shares
Debt and value
Specifically
the weight of debt that is increasing
from 0%
How does borrowing create value?
Financial leverage can create value for a firm because borrowing reduces taxable income
increase value of the firm through tax savings can ultimately create value for the shareholders
WACC = * Re + * Rd * (1 – Tc)
Re = cost of equity
Rd = cost of debt
E = market value of equity
D = market value of debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Required rate of return is also increased because the higher level of debt means the higher chance of default
Full transcript