Case Study corporate finance
Case 28 – An Introduction to Debt Policy and Value
Case 30 – MCI Communications, Corp.: Capital Structure Theory
Table of Contents
Case 28 - An Introduction to Debt Policy and Value 3
Effects of Debt on the Value of the Firm 3
Split of Value between Creditors and Shareholders 4
Source of Value Creation 4
Effects on Value per Share 5
The Benefits of Leveraging for the Shareholders 6
The Macroeconomic Benefit of Debts 7
Koppers Company, Inc. 7
Case 30 – MCI Communications, Corp.: Capital Structure ...view middle of the document...
416). This finding implies that a firm should borrow as much as possible in order to increase its value. In reality, firms finance their operation more conservative, particularly in order to reduce their risk of financial distress. So who benefits from borrowing? There is no clear answer either. On the one hand, one could argue that financial leverage may benefit stockholders in case the return on the capital borrowed is larger than the related costs. Existing bondholders may loose in this case as they face only a higher default risk without getting any additional compensation for it. On the other hand, stockholders are more related to the costs of financial distress in case of bankruptcy compared to bondholders as they have usually an earlier claim on the firm’s asset.
Looking at the tables below, we further discuss the roles of debt and equity in the capital structure of a firm.
As it can be noticed in above table, the cash flow of the firm remains unchanged whereas the discount rate (measured as the WACC) is reduced. According to financial market theory, this reduction should lead to an increase in firm value. More specifically, the value of the assets changes because the required rate of return decreases. Those changes occur on the passive side of the firm’s balance sheet. In simple terms, the firm adjusts its capital structure to maximize the overall value of the firm.
Split of Value between Creditors and Shareholders
So how is the increased value spread between creditors and stockholders? To answer the question, let us first have a look at table 2.
As it is shown, the total value of the firm increases as leverage goes up. The increasing costs of equity are more than compensated by the positive effects of financial leverage. To answer the question regarding the split of the increased value between creditors and stockholders the answer seems to be quite obvious: the stockholders benefit most. However, it should be kept in mind that this increase in value means also a higher risk for stockholders as measured by the costs of equity (up to 17.3% from 13.9%).
Source of Value Creation
While in table 2 is illustrated, where the additional value from an increased leverage is going, we now have a closer look at where the change in value is coming from. For this purpose, we divide the free cash flow of the firm into pure business flows and cash flows resulting from financing effects and discount them at a consistent rate reflecting the cash flows’ risk.
As shown in table 3, the total value of cash flow is increasing if debt is augmented. It is also obvious that this increase in value is generated by the cash flows resulting from financing effects. But how does this gain come about? In fact, table 3 illustrates one of the most important theories in corporate finance, which says that the value of a levered firm is equal to the value of an unlevered firm plus the present value of the tax shield provided by debt (Copeland,...