Question

Radstone, Inc

Part 1- Static Theory

An enduring controversy within financial theory concerns the effect of financial leverage on the value and stock price of a company. Can a company affect its overall value by selecting an optimal financing mix (debt and equity)? The firm’s mix of debt and equity financing is called its capital structure. The essentials of the capital structure and the effect of financial policies on the value of the firm were pioneering work of Noble recipients Modigliani and Miller in 1958 and 1963.¹

The essential question is: Does debt financing create value? If so, how? If not, then why do so many financial mangers try to find the combination of securities that has greatest overall effect on the market value of the firm?

This short case presents a simple model of Modigliani-Miller theorem to highlight the advantage of debt financing and whether there is an optimal capital structure that maximizes the value of the firm. However, it ignores other market imperfections such as bankruptcy and agency problems among security holders that would affect the value of the firm.

Radstone, Inc., a prominent stone fabrication firm was formed 5 years ago to exploit a new continuous fabrication process. Radstone's founders, Jim Rad and Mick Rad, had been employed in the research department of a major integrated-stone fabrication company, but when that company decided against using the new process, they decided to strike out on their own. One advantage of the new process was that it required relatively little capital in comparison with the typical fabrication company, so they have been able to avoid issuing debt financing, and thus they own all of the shares. However, the company has now reached the stage where outside capital is necessary if the firm is to achieve its growth targets. Therefore, they have decided to leverage the company with swapping some of their shares with new debt.

Currently the company has value of $5 million with outstanding shares of 100,000. The company generates $1,538,461.5 in earnings before interest and taxes (EBIT) in perpetuity. The corporate tax rate is 35 percent and all earnings are paid as dividends. The company is considering the effect of $2 million and $2.5 million debt –equity swap on its cost of capital and its value. The cost of debt is 10 percent and the cost of capital is currently 20 percent. Any investment in net working capital and capital expenditure is equal to its depreciation allowances. The corporate tax rate is 35 percent.

Table 1	Current		Debt		Debt
	Capital Structure
Book Value of Debt	$-		$2,000,000		$2,500,000
Book Value of Equity	$5,000,000		$3,000,000		$2,500,000
V=D+E	$5,000,000		$5,000,000		$5,000,000
Market Value of Debt			$2,000,000		$2,500,000
Market Value of Equity
V=D+E
Pretax Cost of Debt	10.00%		10.00%		10.00%
After-Tax Cost of Debt (tax rate 35%)	6.50%		6.50%		6.50%
Market Value Weights of
Debt
Equity
Cost of Equity	20.00%
Weighted-Average Cost of Capital	20.00%
EBIT	$ 1,538,461.50		$   1,538,461.50		$    1,538,461.50
Taxes (@ 35%)
Net Income
+ Depreciation
-change in NWC
-Capital exp.
Free Cash Flow
Value of Firm (FCF/WACC)

Answer 1

Situation 1- cost of equity remains constant
	Current Capital Structure	Debt 1	Debt 2
Book Value of Debt	$0	$2,000,000	$2,500,000
Book Value of Equity	$5,000,000	$3,000,000	$2,500,000
V=D+E (BV)	$5,000,000	$5,000,000	$5,000,000
Pretax Cost of Debt	10.00%	10.00%	10.00%
After-Tax Cost of Debt (tax rate 35%)	6.50%	6.50%	6.50%
Book Value Weights of
Debt	0.00%	40.00%	50.00%
Equity	100.00%	60.00%	50.00%
Cost of Equity	20.00%	20.00%	20.00%
Weighted-Average Cost of Capital (WACC)	20.00%	14.60%	13.25%
EBIT	$1,538,462	$1,538,462	$1,538,462
Interest expense	$0	$200,000	$250,000
EBT	$1,538,462	$1,338,462	$1,288,462
Taxes (@ 35%)	$538,462	$468,462	$450,962
Net Income	$1,000,000	$1,070,000	$1,087,500
EBIT * (1- tax rate@35%)	$1,000,000	$1,000,000	$1,000,000
+ Depreciation - change in NWC - Capital exp.	$0	$0	$0
Free Cash Flow to Firm (FCFF)	$1,000,000	$1,000,000	$1,000,000
Value of Firm (FCFF/WACC)	$5,000,000	$6,849,315	$7,547,170
Market Value of Debt	$0	$2,000,000	$2,500,000
Market Value of Equity	$5,000,000	$4,849,315	$5,047,170
V=D+E (MV)	$5,000,000	$6,849,315	$7,547,170

FCFF = earnings before interest and taxes (EBIT) x (1 - tax rate) + depreciation - long-term investments - investments in working capital
Here, Depreciation + (change in NWC + Capital exp.)
We need either cost of equity or market value of equity to calculate the other value. Since MV of equity is not given, it can be calculated as MV of firm - MV of debt
Cost of equity is assumed to constant. In this situation, the lower cost of debt and tax shield lower the WACC. Hence, even for stable FCFF, the MV of firm increases. This assumption is based on the fact stated in the case that 'ignore the market imperfections such as bankruptcy and agency problems among security holders that would affect the value of the firm.' This indirectly implies that the additional leverage is not seen as a cause of concern by the equity holders and their stated return on equity is constant.
Alternatively, if the additional leverage is a concern for equity holders, we can calculate Cost of equity = net income/ BV of equity. This is because all earnings are paid as dividend. Hence, this is the rate equity holders expect. Also, as per this table, no growth is expected in the earnings. Hence, the MV of firm can be calculated as a perpetuity of FCFF/ WACC. This is a modification of the Gordon Growth model. This gives us situation 2
As seen from situation 1, the FCFF increases with leverage. Since the cost of equity is not increasing with additional leverage, the MV of firm and MV of equity is increasing. However, this is not seen in practice where bankruptcy risk and additional leverage increase the cost of equity and WACC. In situation 2, the MV of firm and MV of equity is decreasing with additional leverage. This is because all the benefit generated from leverage and tax shield is already factored in the cost of equity

Situation 2- cost of equity changes with additional leverage
	Current Capital Structure	Debt 1	Debt 2
Book Value of Debt	$0	$2,000,000	$2,500,000
Book Value of Equity	$5,000,000	$3,000,000	$2,500,000
V=D+E (BV)	$5,000,000	$5,000,000	$5,000,000
Pretax Cost of Debt	10.00%	10.00%	10.00%
After-Tax Cost of Debt (tax rate 35%)	6.50%	6.50%	6.50%
Book Value Weights of
Debt	0.00%	40.00%	50.00%
Equity	100.00%	60.00%	50.00%
Cost of Equity (=net income/ BV of equity)	20.00%	35.67%	43.50%
Weighted-Average Cost of Capital (WACC)	20.00%	24.00%	25.00%
EBIT	$1,538,462	$1,538,462	$1,538,462
Interest expense	$0	$200,000	$250,000
EBT	$1,538,462	$1,338,462	$1,288,462
Taxes (@ 35%)	$538,462	$468,462	$450,962
Net Income	$1,000,000	$1,070,000	$1,087,500
EBIT * (1- tax rate@35%)	$1,000,000	$1,000,000	$1,000,000
+ Depreciation - change in NWC - Capital exp.	$0	$0	$0
Free Cash Flow to Firm (FCFF)	$1,000,000	$1,000,000	$1,000,000
Value of Firm (FCFF/WACC)	$5,000,000	$4,166,667	$4,000,000
Market Value of Debt	$0	$2,000,000	$2,500,000
Market Value of Equity	$5,000,000	$2,166,667	$1,500,000
V=D+E (MV)	$5,000,000	$4,166,667	$4,000,000