______________________________________________ PRIVATE EQUITY in .NET

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48 ______________________________________________ PRIVATE EQUITY
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debt is less than the current cost of equity; thus the expected return on equity can be increased by the use of debt While this option is intuitively attractive, we cannot argue that the total firm value is increased for this reason The second reason for using debt is based on the tax law that allows debt interest to be tax deductions, but recognizes no tax deduction for the return on an equity security We shall see that the tax deductibility of interest can add significantly to the value of a firm with the amount of value added depending on the corporate income before tax, the corporate tax rate, and the amount of new debt The investor tax rates also affect the analysis The third reason is the most important for private equity The debt facilitates accomplishing the acquisition of the firm It helps get the deal done
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Debt Costs Less than Equity
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Assume that debt costs 06 if 5 of the capital is debt and in one period a $1,000 investment has a 10 expected return Note the investment has a higher return than the debt cost There are zero taxes The situation is as shown in Table 51 With 100 percent equity, the stockholders earn 10 With 50 percent debt and 50 percent equity the stockholders can expect to earn 14 This is called "trading on the equity" and it is typical of one justification for using debt (the use of debt enhances the expected return on the stock) An investor who buys both debt and equity (in equal amounts) will again earn the 10 unlevered return Without taxes and with a rational capital market no value is added by substituting debt for equity The investor can replicate the firm's use of
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TABLE 51
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debt by borrowing and can delever the leveraged firm by buying both debt and equity The use of the debt results in a larger spread of outcomes for the stockholders Assume the outcomes at time 1 for the $1,000 investment are as shown in Table 52 With the set of possible outcomes the $500 of initial debt is always paid the contractual amount of $530 The stockholders face the outcomes shown in Table 53 (the equity investment is $500) The spread of outcomes (IRR) on the common stock investment is much larger with the $500 of debt than it was with 100 percent of stock Assume that if $900 of debt is used, the debt cost will be increased to 07 See Table 54 The expected return on the common stock is increased from 10 with no debt, to 14 with 5 debt, to 37 with 9 debt But again there
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50 _________________________________________________ PRIVATE EQUITY
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is no reason to conclude value has been added by the substitution of debt for equity To add value for the stockholders, we must consider corporate taxes
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DEBT USE AND TAXES ____________________
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The conventional valuation model with the firm issuing B of debt in substitution for stock equity assumes: VL = Vu + tB where VL = the value of the leveraged firm Vu = the value of the firm before debt is substituted for equity t = the corporate tax rate B = the amount of debt that is added The assumptions are that the debt added in substitution for stock is outstanding for perpetuity and that there are no costs of financial distress The term tB is equal to the present value of the tax savings from the debt interest deductions (51)
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Example Assume a firm earns $15385 per year before corporate tax and $100 after corporate tax (t = 35) There is no growth and the stockholders use a 08 discount rate
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The value of the unleveraged firm is $1,250 Now assume that $1,000 of 06 debt is substituted for $1,000 of stock The value of the leveraged firm (with no cost of financial distress) is VL = 1,250 + 35(1,000) = $1,600
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