I tried, as an exercise, to reconcile the DCF(FCFF), DCF(FCFE) and Market Value of Debt.
Not only that I failed, it raised additional questions as to NPV concept.
The example is follows.
Investment (Capital) = 500
Debt = 250 (50%), perpetuity bond, market interest rate 9% meaning that market value of debt is 250.
Interest = 250*0.09 = 22.5
Equity = 250 (50%), cost of equity = 12%
Tax = 35%
No capex investment beyond the initial
No Changes in Working capital
Assume no change in probability of default
WACC = 0.5*0.65*0.09 + 0.5*0.12 = 8.925%
FCFF = 50 to perpetuity
FCFE = FCFF – Interest*(1-T) = 50 – 22.5 * 0.65 = 35.375
DCF(FCFF) = FCFF/WACC = 50/0.08925 = 560.224
DCF(FCFE) = FCFE/(cost of equity) = 35.375/0.12 = 294.792
MV(Debt) = DCF(FCFF) – DCF(FCFE) = 560.224 – 294.792 = 265.432
It looks like the debt holders have positive NPV from this debt investment, which cannot be true. At the end of the day, they will get exactly the coupons for perpetuity – and their market value is exactly 250.
So, why is MV (debt) is higher than 250, which was the market value in the first place?
This project creates value (positive NPV). Why is a part of the created value attributed to debt holders? Why does not all created value go to equity holders?
What am I missing?