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# Valuing Debt & Debt Policy

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THEME 1

1. Explain how changes in debt-equity ratio impact the beta of the firm's equity. Provide a mathematical example to support your analysis.

2. What are the ramifications of a firm having a "less than optimal" or "wrong" capital structure?

THEME 2

1. In describing an optimal investment portfolio for someone who is 22 years of age, what would you recommend to them with respect to their distribution of stocks and bonds? Would your recommendation change if the person were 45 years old? Would it change if they were 85 years old?

2. If you were going to assess the riskiness of bonds, what types of characteristics (variables) would you consider? For example, "time" would be a variable (long vs. short-term bonds). Which of the variables that you have listed would be the most important? How would you rank order your considerations?

3. Using the Internet, find an example of how bonds' returns demonstrate the "term structure of interest rates."

4. Why do bonds of different maturities have different yields in terms of the expectations, liquidity, and segmentation hypotheses? Describe how these hypotheses relate to two different situations: 1) when the yield curve is upward sloping; 2) when the yield curve is downward sloping

#### Solution Preview

THEME 1

1. Explain how changes in debt-equity ratio impact the beta of the firm's equity. Provide a mathematical example to support your analysis.

Asset beta refers to an unlevered beta, i.e. beta calculated without regard to financial risk. Asset beta is appropriate in calculating cost of equity capital where there is no debt present in the capital structure. This is also refered to the beta of firm's equity.
S= Equity, D= Debt,
Unlevered Beta= Levered Beta/(1+D/S)
(Ignoring taxes)

By this formula we can interpret that the beta of Firm's equity changes with the change in Debt equity ratio
Situation 1

Unlevered beta (Equity beta) = 0.8/(1+.5)= .8/1.5= .053
If the Levered beta= .8, Debt equity ratio is .5, than Unlevered beta is .53

Situation 2
If debt equity ratio is 1 than the
Unlevered beta (Equity beta) = 0.8/(1+1)= .8/2= .4

If we take taxes also into consideration than:
Then the formula is:
bl = bu* [1 + (1 - T)(D/S)]
where bu is the firm's beta without leverage, T is the corporate tax rate, D is the market value of debt and S is the market value of equity. This is also known as Hamada equation which implies that there is a positive relationship between the degree of financial leverage and a firm's beta.

Situation 1

Use Hamada's equation to find beta:
bL = bU [1 + (1 - T)(D/S)]
= 1.0 [1 + (1-0.4) (20% / 80%) ]
= 1.15
If T= taxrates =40%, D= Debt =20%,S= 80%

Other situations
wd D/S bL
0% 0.00 1.000
20% 0.25 1.150
30% 0.43 1.257
40% 0.67 1.400
50% 1.00 1.600

Thus the beta of equity is changing as given in above table.

2. What are the ramifications of a firm having a "less than optimal" or "wrong" capital structure?
The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of generating funds in the marketplace. Another way to think of the cost of capital is as the opportunity cost of funds, since this represents the opportunity cost for investing in assets with the same risk as the firm. When investors are shopping for places in which to invest their funds, they have an opportunity cost. The firm, given its riskiness, must strive to earn the investor's opportunity cost.

Factors which go in determining right mix:

The Nature of Agency Cost of Debt

The agency cost of debt is associated with monitoring, enforcing, credibly promising, and constraining decisions, and result from the general situation in which the optimization problem for one constituency is suboptimal for another constituency. In terms of the agency costs of debt, Jensen and Meckling (1976) suggest that the potential conflict between equity and debt claimants is presented primarily in terms of wealth expropriation and risk shifting.

Shareholders may capture wealth from bondholders by investing in new projects that are riskier than those presently held in the firm's portfolio. If the projects perform well, shareholders capture most of the gains, while bondholders bear most of the cost (Fama and Miller, 1972). The fact that shareholders of a corporation with outside debt have a call option on the corporate assets and can influence the underlying risk creates a moral hazard problem. Firms typically mitigate this problem by using restrictive covenants (Lehn and Poulsen, 1991; Smith and Warner, 1979). Writing, monitoring, and enforcing these covenants can entail substantial costs including those associated with missed opportunities and inefficient constraints. In addition, even severe constraints will still leave open opportunities to shift risks and rewards (Jensen and Meckling, 1976).

It leads to the premium charged by the Lenders or bondholders to cover additional costs Thus the costs arising from the different interests of shareholders and the bondholders are the agency costs of debt and lead to higher debt financing costs.

Thus the agency costs associated with debt:

? Restrictive covenants meant to protect creditors can reduce firm efficiency.

? Monitoring costs may be expended to insure the firm abides by the restrictive covenants.

They are important to the determination of capital structure because as the level of debt financing increases, the contractual and monitoring costs are expected to increase.
As the use of debt financing increases, the cost of debt and equity both increase at an increasing rate due to financial distress and agency costs. At some point, the use of more debt financing will cause the WACC to increase.

? The Volatility of Revenues?firms with stable revenue streams can safely use a higher debt to boost earnings.
? Asset Specificity (general purpose vs. specialized)?firms with general purpose assets can have a higher debt
? Operating Leverage?firms with a high operating fixed costs should use a lower financial leverage and vice versa
? Growth Rate?lower flotation costs favor the use of debt, but higher uncertainty favors the use of equity
? Profitability?highly profitable firms can grow organically, by using retained earnings
? Taxes?the advantage of financial leverage rises with a firm's tax rate
? Control of the Firm?the effects are important but don't unequivocally favor debt over equity
? Management Attitudes?there is room for managerial judgment (i.e., tastes and preferences) in determining a firm's optimal capital structure
? Capital Market Attitudes and Conditions?rating agency attitudes and monetary policy can affect the choice of capital instrument
? Firm's Internal Conditions?the choice of debt or equity can be influenced by whether management thinks the firm is overvalued or undervalued by the market. Signaling theory is relevant here.
? Financial ...

#### Solution Summary

The solution discusses debt-equity ratios, bond returns, maturities and riskiness.

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