Question

The firm Kappa has just decided to undertake a major new project. As a result, the value of the firm in one year’s time will be either $120 million (probability 0.25), $250 million (probability 0.5) or $360 million (probability 0.25). The firm is financed entirely by equity and has 10 million shares. All investors are risk-neutral, the risk-free rate is 4% and there are no taxes or other market imperfections.

(a) What is the value of the company and its share price?

Kappa decides to issue debt with face value $146 million due in one year and use the proceeds to repurchase shares now. Assume now that bankruptcy costs will be 15% of the value of the firm’s assets in the event of default on debt repayment.

(b) What is the value of the debt now? What is its yield?

(c) What is the expected value of the firm and the price per share? How many shares will be repurchased?

(d) Assume Kappa decides instead to issue debt with face value $100 million due in one year and repurchase shares with the proceeds. What is the firm’s value now? Why? What is its share price?

(e) Explain how the presence of corporate taxes would influence Kappa’s restructuring decision. (100 words)

Answer 1

a)

probablity of value in one year's time

• value of the company =

  	$
  $120*.25	=$30m
  $250*.5	=$125m
  $360m*.25	=$90m
  total	=$245 m

• VALUE =$245M in one year time
• value today=$245m*.962
• =235.69m

share price=[value of firm/no of shares]

=$235.69m/10=$23.569

b)

corporate taxes help kappa restriction decisions in a positive manner. because if there is corporate tax kappa will get interest deduction and the taxable profit will be low so the amount of tax that must be paid will be low.

if there is no interest deduction benefit kappa will not have much positive influence from corporate tax .tax benefit is given when the company is having interest expense is present,there is no much benefit for equity funded companies.so if you are looking it from that angle interest expense has a positive impact for kappa.

Answer 2

$360m 8.25 8909 time. a Valere Gilver is the probability of value in one years $120m 8.25= $250mx .5 = $125m of the company (m-million $30m $2454 ilualue $2454. in one yearthy Share price Seysme No. of shanision lom : valere today) - $2454 x .962 $235.69 m. la Share price = $23.5.69m valley of form Blom No. of shares $23.569 b c Shates worth values of debt now) - 146 4.962 140.452 [As payment due is to be made at end of 1 end of a year © As share is trepurchased :. value of firm = $235.69 M - $140.952 "$95.2384 As $140 gram is repurchased) priupershang $95.2889 $23.8095 4 met * as from shakes are repurchased itsell share repeschased 140.452m 6m (roundedloff 23.564

Now, ils factolue looy. : valere of debt gloomy .762 > $96.2millelmi after reprchase Change of from 7 139. 49 millon 6M "$23. 248. I alw of firm 139.49 mily. Corporate taxes plays a vital role while influencing kappa's restriction deusion there will be a corporate tay then kappa will get to deduction and low at which tay 7 herefore profit will has to be given. an interest is a There is a day benefit ile there is debt deductable axpense, wheareas there no benefit of equity-finered firm. cause As