The unlevered firm expects to earn $250,000 in net operating income each year fo
ID: 2725994 • Letter: T
Question
The unlevered firm expects to earn $250,000 in net operating income each year for the foreseeable future. It has a tax rate of 40% and has a capitalization rate of 8% equal to the industry required return for this type of firm. It calculates that there is a 10% chance the firm will fall into bankruptcy in any given year and that, if bankruptcy does occur, it will impose direct and indirect costs totaling $48,000. Assume that, in the event of bankruptcy, the firm will reorganize and continue operations indefinitely, with a constant 10% probability of reentering bankruptcy. If necessary, use the industry required return for discounting bankruptcy costs. Assume that the firm considers borrowing $500,000 debt at an interest rate 5% and use the proceeds to repurchase an equal amount of outstanding stock. With this level of debt, the likelihood of falling into bankruptcy in any given year increases to 15%, and if bankruptcy occurs then it will impose direct and indirect costs totaling $48,000. With all benefits and costs considered, what is the overall value of the levered firm if the proposed $500,000 debt is used, assuming no personal taxes on debt or equity income?
Explanation / Answer
1.The value tax shield is the amount of money the firm saves beacuse of the tax benefit of rasing debt.
The tax shield is given by:
Tax shield = tc* D
where tc = the prevailing tax rate and
D = the level of the debt that is being raised by the company
Since D = 500,000
the tax rate is 40%,
the value of the tax shield for this amount is:
500000*0.4 = $200,000
Therefore, value of tax shield is $200,000
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.