An Introduction to Debt Policy and Value

Problem 15-9: Capital Structure Analysis Present situation (50% debt): WACC = wd rd(1-T) + wcers = (0.5)(10%)(1-0.15) + (0.5)(14%) = 11.25%. V = FCF/WACC = (EBIT)(1 − T)/WACC = ($13.24)(1 0.15)/ 0.1125 = $100million 70 percent debt: WACC = wd rd(1-T) + wcers = (0.7)(12%)(1-0.15) + (0.3)(16%) = 11.94%. V = FCF/WACC = (EBIT)(1 − T)/WACC = ($13.24)(1 0.15)/ 0.1194 = $94.26million 30 percent debt: WACC = wd rd(1-T) + wcers = (0.3)(8%)(1-0.15) + (0.7)(13%) = 11.14%. V = FCF/WACC = (EBIT)(1 − T)/WACC = ($13.24)(1 0.15)/ 0.1114 = $101.2million

The 20%/9% Bonds and Common Stock option does not generate as positive capital structure as 50%/50% option. Although EPS scores are the same for year nine, net income is reduced to 39,680 due to having to pay interest of 14,400 on bonds while the 50/50 option generates a net income of 49,049 and pays no interest on bonds and issues dividends. In year ten, both capital structures offer an EPS of .032 however the net income is 9,380 less than the 50/50 option. In years 11, 12, and 13, the 20%/9% Bonds and Common Stock option EPS and net income results decline while the EPS and net income results increase for the 50/50 option.

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Using debt is also advantageous to existing owners because of the effect of financial leverage. When companies use debt to provide addition capital for their business operations, equity owners get to keep any extra profits generated by the debt capital, after any interest payments. Given the same amount of equity investments, equity investors have a higher return on equity because of the additional profits provided by the debt capital. As long as using debt doesn’t threaten the financial soundness of a company in times of difficulties, equity owners welcome certain debt uses to help enhance their investment

In brief, citizens and companies will get a loan from a bank but when the US Government needs a loan it issues debt by selling Treasury financial instruments to other federal government agencies, people, companies, state- and local-governments, as well as to such equivalents abroad (Bureau of the Fiscal Service, 2013). The deficit is the ratio of spending and revenues in one year, but the national debt or federal debt is the sum of all previous deficits, less whatever sum the federal government has subsequently repaid. Hence, every annual government deficit due to borrowing is added to the national (federal) debt. A government surplus can reduce some of the national debt. Annually, the national debt incurs interest to be paid by the government which is linked to overall government spending (National Priorities Project, 2016).

Pretax cost of debt= 5.88%, Tax Rate= 40%, Weight of equity = 77.8%, Cost of Equity= 10.95%, Weight of debt = 22.2%

Weight of debt * Cost of debt + weight of equity * Cost of equity

Sovereign debt can be characterized as the debt acquired by governments, regularly those of creating nations, to remote financial specialists looking for an aggressive return. Quite, this definition avoids a few different sorts of financing accessible in the worldwide money related market, for example, government debt to open foundations, private obtaining in global capital markets, and direct outside venture.

Our analysis attempts to answer the question, “What are the things a company must consider when analyzing a new investment or project?” According to the text, a firm’s first objective when deciding to take on new debt should be that its return on net assets (RONA) should be greater than its weighted average cost of capital (WACC). Since we are working with an income statement only and do not have an amount for net assets, we will instead use return on invested capital (ROIC), which measures how well a company is using its money to generate returns. Comparing a company 's return on capital (ROIC) with its cost of capital (WACC) reveals whether invested capital was used effectively. From our spreadsheet calculations we see that using our estimated operating profit provides us with a 19.9% return on invested capital with only a 7.2% weighted average cost for that same capital. If these numbers are even close to correct, George should definitely make the move.

Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restaurant chain. The company’s EBIT was $50 million last year and is not expected to grow. The firm is currently financed with all equity and it has 10 million shares outstanding. When you took your corporate finance course, your instructor stated that most firms’ owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm’s investment banker the following estimated

WACC is the rate used to discount future cash flows of a firm to their present value. By minimising WACC firms are able to increase the value of the firm. For debt to affect value, there have to be tangible benefits and costs associated with using debt instead of equity. If the benefits exceed the costs, there will be a gain in value to equity investors from the use of debt. If the benefits are less than the costs, increasing debt will lower value (Myers, 2001). Following a $3 billion leveraged recapitalisation, the investment grade of Wrigley decreases from AAA to BB/B and consequently the cost of debt increases to 13% (see appendix 9) which is greater than the post-capitalisation cost of equity of 9.84% (see appendix 8). It is for this reason that the WACC increases from 9.24% to 9.49% (see appendices 5 - 10) which results in a reduction in firm value.

The cost of debt (kd) rate of 13% was used after we assessed the key industrial financial ratios and compared them with that of Wrigley’s (See Appendix 2) to conclude that it was in the range between the BB rate of

1a. Please use the capital asset pricing model to estimate the cost of equity. At the date of the case, the 74 over T-bonds. Which beta, risk-free rate, and risk premium did you use? Why? Financing Components Debt Equity Market Values Weight Cost of Capital (After Tax) $ 6,823,736,197 0.85 3.72% $ 1,176,263,803 0.15 28.18% Total: $ 8,000,000,000 1.00 WACC WACC Inputs: Beta: Risk-Free Rate: Market Risk Premium: Pre-tax Cost of Debt: Income Tax Rate:

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

24) Lever Brothers has a debt ratio (debt to assets) of 40%. Management is wondering if its current capital structure is too conservative. Lever Brothers’ present EBIT is $3 million, and profits available to common shareholders are $1,560,000, with 342,857 shares of common stock outstanding. If the firm were to instead have a debt ratio of 60%,