Introduction to Debt Policy

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 debt's 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 holders

* Using 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 firm's operations, if it uses no debt. The greater the firm's business risk, the lower its optimal debt ratio.

* The firm's 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 firm's 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 Assets

0% Debt 25% Debt 50% Debt

100% Equity 75% Equity 50% Equity

Book Value of Debt 0 2500 5000

Book Value of Equity 10000 7500 5000

Market Value of Debt (D) 0 2500 5000

Market Value of Equity (E) 10000 8350 6700

Pre-tax Cost of Debt (RD) 0.05 0.05 0.05

After-tax Cost of Debt (1-Tc)*RD 0.033 0.033 0.033

Market Value Weights of:

Debt WD = D / (D + E) 0 0.2304 0.4274

Equity (WE) = E / (D + E) 1 0.7696 0.5726

Un-Levered Beta (B U) 0.8 0.8 0.8

Levered Beta B L = BU*(1+(1-Tc) (D/E)) 0.8 0.9581 1.1940

Risk-free Rate (Rrf) 0.05 0.05 0.05

Market Premium (MRP) 0.06 0.06 0.06

Cost of Equity RE = Rrf + bL * MRP 0.098 0.1075 0.1216

Weighted Average Cost of CapitalWACC = (1-Tc)WDRD+WERE 0.098 0.0903 0.08376

EBIT 1485.00 1485.00 1485.00

(Taxes (@34%)) -504.90 -504.90 -504.90

EBIAT 980.10 980.10 980.10

Depreciation 500.00 500.00 500.00

(Capital Expenses) -500.00 -500.00 -500.00

Change in Net Working Capital 0.00 0.00 0.00

Free Cash Flow (FCF) 980.10 980.10 980.10

Value of Assets (FCF/WACC) 10001.01 10851.11 11701.19

The 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 Hamada's equation BL= BU (1+(1-TC) (D/E))

Analysis 2: Valuation of the Debt & Equity

0% Debt 25% Debt 50% Debt

100% Equity 75% Equity 50% Equity

Cash Flow to Creditors:

Interest (Int) 0.00 125.00 250.00

Pre-tax Cost of Debt (Rd) 0.05 0.05 0.05

Value of Debt (Int/Rd) 0.00 2500.00 5000.00

Cash Flow to Shareholders:

EBIT 1485.00 1485.00 1485.00

Interest (Int) -0.00 -125.00 -250.00

Pretax profit 1485.00 1360.00 1235.00

Taxes (@34%) -504.90 -462.40 -419.90

Net Income 980.10 897.60 815.10