Cavu Air, Inc. has $3,500,000 in excess cash. They plan to use this cash to reti

Question

Cavu Air, Inc. has $3,500,000 in excess cash. They plan to use this cash to retire its outstanding debt or repurchase equity. The bank that holds the debt is willing to sell it back to Cavu for $3,500,000 and not charge any transaction fees. Once Cavu becomes an all equity firm, it will stay unlevered in perpetuity. If they do not retire the debt, the company will use the $3,500,000 to buy back some of its stock from the market. This also has no transaction fees. Regardless of capital structure, the firm will generate $1,500,000 of annual earnings before interest and taxes in perpetuity. At the end of each year, the company immediately pays out all earnings as dividends. The corporate tax rate is 35% and the required rate of return is 20% The personal tax rate on the interest income is 25% and there are no taxes on equity distribution. Assume no bankruptcy costs. Answer the following: 1. What is the value of Cavu, if it decides to retire all of its debt and become an unlevered firm? 2. What is the value of Cavu, if it decides to repurchase stock instead of retiring its debt? 3. Assume, that expected bankruptcy costs have a present value of $450,000 How does this influence Cavu's decision? Excess cash Annual EBIT Corporate tax rate Unlevered cost of equity Interest income tax rate Bankruptcy costs $3,500,000 $1,500,000 35% 20% 25% $450,000

Explanation / Answer

1. Value of Cavu, if it decides to retire all of its debt and become an unlevered firm :

Formula :

VU = EBIT(1-corporate tax rate)/Rate of return on equity

= $1,500,000(1-0.35)/0.20

= $4,875,000/-

2. Value of Cavu, if it decides to repurchase stock instead of retiring its debt :

Formula :

VL = VU (+) [1-{(1-corporate tax rate)/(1-personal tax rate on interest income)}] * Excess Cash

= $ 4,875,000+[1-{(1-0.35)/(1-0.25)}] * $3,500,000

= $ 5,341,666.67 (approx)

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