FIN 450
Rami Ahmed Al Hasan @16253
Elias Elkoussa @17067
May Mohammed @14325
Deena Shalab@16457
Reem Hani Arab @16185
CASE 4
An Introduction to Debt Policy and Value
1
(Table format and content from case)
0% debt/100% equity 25%debt/75% equity 50%debt/50% equity
BV of debt 0 $2,500 $5,000
BV of equity $10,000 $7,500 $5,000
MV of debt 0 $2,500 $5,000
MV of equity $10,000 $8,350 $6,700
Pretax cost of debt 0.07 0.07 0.07
After-tax cost of debt 0.0462 0.0462 0.0462
Market Weight of Debt 0 0.23 0.43
Market Weight of Equity 1.0 0.77 0.57
Un-levered Beta 0.8 0.8 0.8
Risk free rate 0.07 0.07 0.07
Market premium 0.086 0.086 0.086
Cost of equity 13.88% 15.4% 20.8%
WACC 13.88% 13.5% 13.8%
EBIT $2,103 $2,103 $2,103
- Taxes - 34% $1,388 $1,388 $1,388
EBIAT $1,388 $1,388 $1,388
+ Depreciation $500 $500 $500
- Cap exp. $(500) $(500) $(500)
FCF 1,388 1,388 1,388
Value of assets $10,000 $10,281 $10,058
The following are calculations for:
0% debt:
Cost of equity = Rf + Bu (Km - Krf) = 0.07 + 0.8(0.086) = 13.88%
WACC = WD*Kd+ Ws*rs = 0 + 13.88 = 13.88%
NOTE THAT: Km - Krf = Market Risk Premium
25% debt
Rs = r0 + D/E(r0-rb) = 13.88 + 1/3(13.88- 7) = 16.1
Alternatively:
Bl = Bu {1+ (1-T) (D/E)} = .8{1+ (1- .34) (1/3) = .976
Cost of equity = Rf+ Bl (Km - Krf) = 0.07+ .976 (0.086) = 15.4%
WAAC = .23*0.0462+ .77* 0.161= 13.5%
NOTE THAT: Km - Krf = Market Risk Premium
50% debt
Rs = r0 + D/E(r0-rb) = 13.88 + 1(13.88- 7) = 20.8%
WACC = .43*0.0462+ .57*.208= 13.8%
Above we see that more debt has increases the value of assets for the f ...