Question

Simpson Ltd is a small IT company, which has 2 million shares outstanding and a share price of $20 per share. The management of Simpson plans to increase debt and suggests it will generate $3 million tax shield benefits in total present value. If the share price of Simpson increased to $21 on the announcement of this plan, calculate the total value of financial distress cost expected by the market. Assume the market is efficient and the trade-off theory holds.

Answer 1

PV of tax shield is $3 million but the increase in equity value is (21-20)*2 = $2 million, so the total value of financial distress cost expected by the market is 3-2 = $1 million.