Question

Overnight Publishing Company (OPC) has $2.9 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 willing to sell it back to OPC for $2.9 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 $2.9 million in cash to buy back some of its stock on the open market. Repurchasing stock also has no transaction costs. The company will generate $1,340,000 of annual earnings before interest and taxes in perpetuity regardless of its capital structure. The firm immediately pays out all earnings as dividends at the end of each year. OPC is subject to a corporate tax rate of 24 percent and the required rate of return on the firm’s unlevered equity is 15 percent. The personal tax rate on interest income is 20 percent and there are no taxes on equity distribution. Assume there are no bankruptcy costs.

  

a.	What is the value of OPC if it chooses to retire all of its debt and become an unlevered firm? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to the nearest whole number, e.g., 1,234,567.)
b.	What is the value of OPC if it decides to repurchase stock instead of retiring its debt? (Hint: Use the equation for the value of a levered firm with personal tax on interest income from Problem 9 in the textbook.) (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to the nearest whole number, e.g., 1,234,567.)
c.	What is the value of OPC if the expected bankruptcy costs have a present value of $575,000? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to the nearest whole number, e.g., 1,234,567.)

Answer 1

a. Since OPC is unlevered so Debt = Interest = 0 and also pays all its earnings as dividends

Perpetual per year Dividends = Net Income = (EBIT - interest)(1- Corporate tax rate) =(1340000 - 0)(1-24%) = 1340000 x 0.76 = $1018400

We know that present value of perpetuity = Cash flow / discount rate

Since dividends form a perpetuity so using the above formula we get,

Value of OPC if its is unlevered = Present value of dividends = Perpetual dividends per year / Unlevered cost of equity = 1018400 / 15% = $6789333.3333 = $6789333 (rounded to nearest whole dollar)

Hence value of OPC if it chooses to retire all of its debt and become an unlevered firm = $$6789333

b) If OPC decides to repurchase stock, then it it is levered firm with Value of Debt = D = $2.9 million = $2900000

corporate tax rate = Tc = 24%, personal tax rate on stock or dividends = Ts = 0% and personal tax rate on interest income = Td = 20%

Since OPC is a levered firm, using miller model with personal taxes we get

So Value of OPC = Value of Levered firm = Value of unlevered + [1- {(1-Tc)(1-Ts) / (1-Td)}] x D = 6789333.3333 + [1- {(1-24%)(1-0%) / (1-20%)}] x 2900000 = 6789333.3333 + [ 1 - {(0.76)(1) / (0.80)}} x 2900000 = 6789333.3333 + [1-0.95] x 2900000 = 6789333.3333 + 0.05 x 2900000 = 6789333.3333 + 145000 = 6934333.3333 = 6934333 (rounded to nearest whole dollar)

So value of OPC if it decides to repurchase stock instead of retiring its debt =6934333

c) OPC will only have bankruptcy costs only when it is levered,

Value of OPC with Bankruptcy costs = Value of OPC without Bankruptcy costs - Expected present value of Bankruptcy costs

Value of OPC with Bankruptcy costs = Value of levered OPC - Expected present value of Bankruptcy costs = 6934333.33 - 575000 = 6359333.33 = 6359333 (rounded to nearest whole dollar)

Value of OPC if the expected bankruptcy costs have a present value of $575,000 = $6359333

Note: Bankruptcy costs do not affect unlevered firm, Value of unlevered OPC firm will remain same as part a) despite of bankruptcy costs.