Question

Overnight Publishing Company (OPC) has $4.3 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 $4.3 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 $4.3 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 $1,480,000 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 35 percent, and the required rate of return on the firm's unlevered equity is 20 percent. The personal tax rate on interest income is 25 percent, and there are no taxes on equity distributions. Assume there are no bankruptcy costs. When personal taxes on interest income and bankruptcy costs are considered, the general expression for the value of a levered firm in a world in which the tax rate on equity distributions equals zero is: VL = VU+ (1 - [(1 - dy(1 - 180' B-C(B) where: VL = the value of a levered firm. VU = the value of an unlevered firm. B = the value of the firm's debt. tc = the tax rate on corporate income. te = the personal tax rate on interest income. C(R= the present value of the costs of financial CB) distress.

Answer 1

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VOR. * 07.09 ENG 14 01 2000 2 RR RT RU RV RW RX RY RZ SA SB SC SD SE SE SG S H A RS OVERNIGHT VALUE OF UNLEVERED FIRM = VU = EBIT*(1-t)/r0 VALUE OF UNLEVERED FIRM = VU = 1480000*(1-0.35)/0.20 VALUE OF UNLEVERED FIRM = VU = 4810000 9 VALUE OF LEVERED FIRM = VL = VALUE OF LEVERED FIRM = VL= VALUE OF LEVERED FIRM = VL = VU+ (1 - ((1-tc)/(1-tB)))*B 4810000 + (1-(1-0.35)/(1-0.25)))* 4300000 5383333 10 b BANKRUPTCY COSTS DOES NOT AFFECT THE UNLEVERED FIRM, AS THERE IS NO DEBT, IT CAN NOT BE FORCED INTO BANKRUPTCY VALUE OF UNLEVERED FIRM = VU = 4810000 BANKRUPTCY DOES AFFECT THE LEVERED FIRM VALUE OF LEVERED FIRM = VL = VU+ (1 - ((1-C)/(1-tB)))*B-C(B) VALUE OF LEVERED FIRM = VL = 4810000 + (1-(1-0.35)/(1-0.25)))*4300000 - 580000 VALUE OF LEVERED FIRM = VL = 4803333 ... pv, Iv, annuily CAP STRU VALUE PM, PMT loan with points LOCK BOX DILUTION DOLLAR COST AVG EXPO NPER APR CPI ear FVA pva 52 53 STATE 56 57 58 ... 6