10. Personal Taxes, Bankruptey Costs, and Firm Value Overnight Publishing Compan

Question

10. Personal Taxes, Bankruptey Costs, and Firm Value Overnight Publishing Company (OPC) has $2.5 million in excess cash. The firm plans to use this cash either to retire all of its outstanding debt or to repurchase equity The firm's debt is held by one institution that is wiling to sell it back to OPC for $2.5 million. The institution will not charge OPC any transaction costs. Once OPC becomes an all-equity firm, it will remain unlevered forever. If OPC does not retire the debt, the company will use the $2.5 million

Explanation / Answer

Ans A)

If the company decides to retire all of its debt, it will become an unlevered firm. The value of an all equity firm is the present value of the after tax cash flow to equity holders, which will be: VU = (EBIT)(1 - tC) / R0 VU = ($1,300,000)(1 .35) / .20 VU = $4,225,000

Since the Co. has decided to retire all of its debt , It will become an unlevered. Hence the value of an equity firm is the present value of the after tax cash flow to equity holders.

V U= (EBIT)(1 – t C ) / r0

($1,300,000)(1 .35) / .20 VU = $4,225,000

Ans B)

Since there are no bankruptcy costs, the value of the company as a levered firm is:

VL = VU + {1 [(1 tC) / (1 tB)]} B VL= $4,225,000 + {1 [(1 .35) / (1 .25)]} $2,500,000 VL = $4,558,333.33

Because the value of the firm is higher with the repurchase stock alternative rather than the retire debt alternative, the firm should choose the former.

Ans C)

The bankruptcy costs would not affect the value of the unlevered firm since it could never be forced into bankruptcy. So, the value of the levered firm with bankruptcy would be: VL = VU + {1 [(1 tC) / (1 tB)]} B C(B) VL= ($4,225,000 + {1 [(1 .35) / (1 .25)]} $2,500,000) $400,000, VL= $4,158,333.33 . The company should choose the all equity plan with this bankruptcy cost.

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