Introduction to Debt Policy Essay Example For Students

Introduction to Debt Policy Essay When a firm grows, it needs capital, and that capital can come from debt or equity. Debt has two important advantages. First, interest paid on Debt is tax deductible to the corporation. This effectively reduces the debts effective cost. Second, debt holders get a fixed return so stockholders do not have to share their profits if the business is extremely successful. Debt has disadvantages as well, the higher the debt ratio, the riskier the company, hence higher the cost of debt as well as equity. If the company suffers financial hardships and the operating income is not sufficient to cover interest charges, its stockholders will have to make up for the shortfall and if they cannot, bankruptcy will result. Debt can be an obstacle that blocks a company from seeing better times even if they are a couple of quarters away. Capital structure policy is a trade-off between risk and return:Using debt raises the risk borne by stock holdersUsing more debt generally leads to a higher expected rate on equity. There are four primary factors influence capital structure decisions:Business risk, or the riskiness inherent in the firms operations, if it uses no debt. The greater the firms business risk, the lower its optimal debt ratio. The firms tax position. A major reason for using debt is that interest is tax deductible, which lowers the effective cost of debt. However if most of a firms income is already sheltered from taxes by depreciation tax shields, by interest on currently outstanding debt, or by tax loss carry forwards, its tax rate will already be low, so additional debt will not be as advantageous as it would be to a firm with a higher effective tax rate. Financial flexibility or the ability to raise capital on reasonable terms under adverse conditions. Corporate treasurers know that a steady supply of capital is necessary for stable operations, which is vital for long-run success. They also know that when money is tight in the economy, or when a firm is experiencing operating difficulties, suppliers of capital prefer to provide funds to companies with strong balance sheets. Therefore, both the potential future need for funds and the consequences of a funds shortage influence the target capital structure- the greater the probable future need for capital, and the worse the consequences of a capital shortage, the stronger the balance sheet should be. Managerial conservatism or aggressiveness. Some managers are more aggressive than others; hence some firms are more inclined to use debt in an effort to boost profits. This factor does not affect the true optimal or value maximizing capital structure but it does influence the manager in determining target capital structure. Analysis 1: Valuation of the Assets0% Debt25% Debt50% Debt100% Equity75% Equity50% EquityBook Value of Debt025005000Book Value of Equity1000075005000Market Value of Debt (D)025005000Market Value of Equity (E)1000083506700Pre-tax Cost of Debt (RD)0.050.050.05After-tax Cost of Debt (1-Tc)*RD0.0330.0330.033Market Value Weights of:Debt WD = D / (D + E)00.23040.4274Equity (WE) = E / (D + E)10.76960.5726Un-Levered Beta (B U)0.80.80.8Levered Beta B L = BU*(1+(1-Tc) (D/E))0.80.95811.1940Risk-free Rate (Rrf)0.050.050.05Market Premium (MRP)0.060.060.06Cost of Equity RE = Rrf + bL * MRP0.0980.10750.1216Weighted Average Cost of CapitalWACC = (1-Tc)WDRD+WERE0.0980.09030.08376EBIT1485.001485.001485.00(Taxes (@34%))-504.90-504.90-504.90EBIAT980.10980.10980.10Depreciation500.00500.00500.00(Capital Expenses)-500.00-500.00-500.00Change in Net Working Capital0.000.000.00Free Cash Flow (FCF)980.10980.10980.10Value of Assets (FCF/WACC)10001.0110851.1111701.19The value of Assets is given by the Free Cash Flows divided by the weighted average cost of capital and changes with the financing side effects of the capital structure. The Cash flows are unaffected by the Capital structure changes, however the WACC decreases as the weight of debt increases. This leads to a greater value of assets (at 50% debt, it is $11701.19 which is greater than that at 0% debt). The capital structure that maximizes stock price is also the one that minimizes the WACC. Another observation of the above table shows that increasing Debt increases Beta (a measure of risk, this is consistent with the Hamadas equation BL= BU (1+(1-TC) (D/E))Analysis 2: Valuation of the Debt Equity0% Debt25% Debt50% Debt100% Equity75% Equity50% EquityCash Flow to Creditors:Interest (Int)0.00125.00250.00Pre-tax Cost of Debt (Rd)0.050.050.05Value of Debt (Int/Rd)0.002500.005000.00Cash Flow to Shareholders:EBIT1485.001485.001485.00Interest (Int)-0.00-125.00-250.00Pretax profit1485.001360.001235.00Taxes (@34%)-504.90-462.40-419.90Net Income980.10897.60815.10Depreciation500.00500.00500.00Capital Expenses-500.00-500.00-500.00Change in Net Working Capital0.000.000.00Debt Amortization0.000.000.00Residual Cash Flow (RCF)980.10897.60815.10Cost of Equity (From Analysis 1: RE)0.0980.10750.1216Value of Equity (RCF/RE)10001.018351.116701.19Value of Equity + Value of Debt10001.0110851.1111701.19As the two sides of the balance sheet should match-up, the Values of Assets from Analysis 1 would be equal to the sum of the Value of Equity and Debt from the above Analysis 2. When the firm levers up the value of its debt component rises and the value of its equity component shrinks. But, the overall value of the firm goes up (the pie increases). Frederick Douglas To Thomas Jefferson EssayValue to Society: Society is better off if firms use some debt in their capital structure. Firms with revenue generating and good projects would be able to acquire (otherwise impossible) capital because of the resource allocation of leverage medium. Institutions with excess capital can invest in firms that increase their wealth, firms wealth and provide better products and services to the society as a whole. Debt unlike equity has to be serviced regularly and interest payments are required to be made on time. This has several benefits in limiting the control that managers have on free cash flow. Managers who own equity in the firm do not resort to shirking their duties, as an increased NPV of the project will yield them high returns personally. Raising debt does not dilute the equity of the managers and keeps them motivated to work harder. Debt limits free cash flows as it demands timely payment of interest. Managers cannot reward themselv es with perquisites, as they have to make interest payments and retire debt. This keeps a check on the managers who may want to put their hand in the till and help themselves at the cost of shareholders (and society). Debt lowers the agency costs arising between management and shareholders. Therefore, the new debt from leveraging can be thought of as a type of control device for shareholders. For companies in high growth areas, debt is not a great avenue to raise capital as competitive pressures and uncertain nature of cash flows can push them into bankruptcy in the presence of debt. However for slow growth companies with strong balance sheets and steady business, debt is the best avenue in the interest of the equity holders. Analysis 7: Re-capitalization of Koppers Company Inc. (all values in thousands). Before RecapitalizationAfter RecapitalizationBook Value Balance SheetsNet Working Capital212,453212,453Fixed Assets601,446601,446Total Assets813,899813,899Long-term Debt172,4091,738,095Deferred Taxes195,616195,616Preferred Stock15,00015,000Common Equity430,874-1,134,812Total Capital813,899813,899Market Value Balance SheetsNet Working Capital212,453212,453Fixed Assets1,618,0811,618,081PV debt tax shield (Long-term Debt * Tax Rate)58,619590,952Total Assets1,889,1532,421,486Long-term debt172,4091,738,095Deferred Taxes00Preferred Stock15,00015,000Common Equity1,701,744668,391Total Capital1,889,1532,421,486Number of Shares28,12828128Price per Share60.5023.76Value to Public ShareholdersCash Received = (Debt After Recap Debt Before Recap)01,565,686Value of Shares = (Value of Common Equity)1,701,744668,391Total Value1,701,7442,234,077Total per share = (Total Value)/(No. of Shares) 60.5079.43Before re-capitalization, the weight of debt of the Koppers firm is around 9.1% (172,409 / 1,889,153) and the share price is $60.50. Issuing a debt of $1,738,095,000 has changed the capital structure of the firm and the new weight of Debt is 71.8% (1,738,095 / 2,421,486). Though, the share price has decreased to $23.76 after re-capitalization, shareholders have a cash flow of $79.43 due to the dividend of $55.67 (79.43 23.76) paid out. Share Price before Re-capitalization$60.50New Share Price after Re-capitalization (SP)$23.76Number of Shares (N)28,128Value of Dividend Paid Out (D)$1,565,686Dividend Distributed per share (Div/share = D/N)$55.67Total Value to Shareholder (SP + Div/Share)$79.43