Progressive Home Health Care Inc. is a for-profit provider of home health care s
ID: 2701469 • Letter: P
Question
Progressive Home Health Care Inc. is a for-profit provider of home health care services in the Pacific Northwest. At present, it has EBIT of $2 million per year, no debt, and a market value of approximately $12 million. Although management is pleased with the good financial condition of Progressive, they are also concerned that the firm might be the target of a potential hostile takeover by a large competitor. Therefore, Progressive is considering issuing debt to buy back shares, the interest on which would be tax deductible (its tax rate is 40 percent). Management recognizes that as the amount of debt increases, both the value of the firm and the risk of financial distress increase. The CFO estimates that the present value of any future financial distress costs is $8 million, and that the probability of distress increases with the amount of debt in the following steps:Explanation / Answer
BIT :
2.00
millions
Debt :
-
Market value :
12.00
millions
Tax rate :
40.00%
PV of financial distress cost :
8.00
millions
In current scenario, cost of equity = cost of capital.
Value of firm = EBIT*(1-tax rate)/Cost of capital
Substituting the values in above equation,
Cost of capital :
10.00%
Cost of equity :
10.00%
======================================================================================================================================================
The following table calculates the optimal level of debt :-
Value of firm = Value of unlevered firm + Tax shield on Debt.
where,
Tax shield on Debt = Debt value * tax rate.
Value of debt
Value of Equity
Value of firm
-
12,000,000.00
12,000,000.00
> Value of unlevered firm
2,500,000.00
10,500,000.00
13,000,000.00
5,000,000.00
9,000,000.00
14,000,000.00
7,500,000.00
7,500,000.00
15,000,000.00
10,000,000.00
6,000,000.00
16,000,000.00
12,500,000.00
4,500,000.00
17,000,000.00
15,000,000.00
3,000,000.00
18,000,000.00
20,000,000.00
-
20,000,000.00
> High firm value
The optimal level of debt is 20 millions dollars.
BIT :
2.00
millions
Debt :
-
Market value :
12.00
millions
Tax rate :
40.00%
PV of financial distress cost :
8.00
millions
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