The unlevered firm expects to earn $250,000 in net operating income each year fo

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

Value of Unlevered firm =Present Value of after tax EBIT- PV of bankruptcy costs Value (UL) (250000*0.6/0.08)-((10%*48000) 1870200 Value of levered firm=PV of Unlevered firm+PV of Tax benefits of Debt-PV of Expected Bankruptcy cost from Debt)                                            = 1870200+(40%*500000)-(15%*48000) 2063000

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