Dream, Inc., has debt outstanding with a face value of $6 million. The value of
ID: 2564905 • Letter: D
Question
Dream, Inc., has debt outstanding with a face value of $6 million. The value of the firm if it were entirely financed by equity would be $17.95 million. The company also has 380,000 shares of stock outstanding that sell at a price of $36 per share. The corporate tax rate is 35 percent. What is the decrease in the value of the company due to expected bankruptcy costs? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)
Dream, Inc., has debt outstanding with a face value of $6 million. The value of the firm if it were entirely financed by equity would be $17.95 million. The company also has 380,000 shares of stock outstanding that sell at a price of $36 per share. The corporate tax rate is 35 percent. What is the decrease in the value of the company due to expected bankruptcy costs? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)
Explanation / Answer
Note for understanding : A firm is said to be in financial distress when it faces difficulty making payments to creditors or lenders which ultimately may lead to bankruptcy of the entity. Thus more debt a company have to use for its operations the greater risk of existence of financial distress.
Financial distress costs = Value of unlevered firm + Tax shield - Value of levered firm
Where ,
Value of unlevered firm = value of the firm if it were entirely financed by equity = $17,950,000 (given)
Value of levered firm = value of the firm when it is also finance by debt = 380,000 shares * $ 36 = $13,680,000
Tax shield = Tax saving due to debt financing = $6,000,000 * .35 = $2,100,000
Therefore, Financial distress costs of Dream Inc = $17,950,000 + $2,100,000 - $13,680,000 = $6,370,000
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