Problem 5 (15 points) Big Blue Mango (BBM) is an all-equity clothing retailer wi

Question

Problem 5 (15 points) Big Blue Mango (BBM) is an all-equity clothing retailer with a current share price of $10.00 and with 25 million shares outstanding. Suppose that BBM announces plans to lower its corporate taxes by borrowing $100 million and using the proceeds to repurchase shares. a) Assuming perfect capital markets, what is the share price for BBM after this announcement? (2) Suppose that BBM pays corporate taxes of 35% and that shareholders expects the change in debt to be permanent. Assuming that capital markets are perfect except for the existence of corporate taxes, what is the share price for BBM after this announcement? (3) Suppose that BBM pays corporate taxes of 35% and that shareholders expects the change in debt to be permanent. Assume that capital markets are perfect except for the existence of corporate taxes and financial distress costs. If the price following the announcement, then what is the present value of BBM s financial distress cost? of BBM's stock rises to S10.85 per share

Explanation / Answer

a) Equity Value = $10 * 25 million = $250 Million

with $100 million, no.of shares purchased = 100/10 = 10 Million

Shares left = 25 - 10 =15 Million

After putting $100 million debt, Remaining equity = 250 million - 100 milion = $ 150 million

New Share price = Remaining Equity /Shares left = 150/15 = $10

b) Tax benefit passed onto equity holders = Tax rate*Debt = 0.35*100 = $35 million

Remaining Equity Value now becomes = 150 + 35 = $185 million

Share price = $185 million/15 = $ 12.33 per share

c) Total Equity Value now = $10.85*15 million = $162.75 million

It should have been $185 million had it not been the cost of financial distress

Therefore, PV of financial distress cost = 185 - 162.75 = $ 22.25 million

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