Question

Azumah Corporation plans to finance a new investment with leverage. Azumah Corporation plans to borrow $ 48.6 million to finance the new investment. The firm will pay interest only on this loan each​ year, and it will maintain an outstanding balance of $ 48.6 million on the loan. After making the​ investment, Azumah expects to earn free cash flows of $ 10.7 million each year.​ However, due to reduced sales and other financial distress​ costs, Azumah's expected free cash flows will decline to $ 9.7 million per year. Azumah currently has 5.2 million shares​ outstanding, and it has no other assets or opportunities. Assume that the appropriate discount rate for​ Azumah's future free cash flows is 8.4 % and​ Azumah's corporate tax rate is 30 %. What is​ Azumah's share price today given the financial distress costs of​ leverage?

Answer 1

Share price = Firm's value / No. Of outstanding shares

Here,

i) Firm's value = Free cash flow due to distress costs / Discount factor

Free cash flow = $9.70 million per year

Discount factor = 8.40% or 0.0840

Firm's value = $9.70 million per year / 0.0840

Firm's value = $115.48 million

ii) No. Of outstanding shares = 5.2 million shares

Now, put the values into formula

Share price = $115.48 million / 5.2 million shares

Share price = $22.21 per share

Azumah's share price today = $22.21 per share

Note : Tax effect is already considered in net profit which is included in free cash flow. Hence no further effect of tax will he given.