Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

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

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 firms 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 $915,000 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 22 percent, and the required rate of return on the firms unlevered equity is 20 percent. The personal tax rate on interest income is 37 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 TC)/(1 TB)]} B C(B)
where:
VL = the value of a levered firm.
VU = the value of an unlevered firm.
B = the value of the firms debt.
TC = the tax rate on corporate income.
TB = the personal tax rate on interest income.
C(B) = the present value of the costs of financial distress.
a. What is the value of the company 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 dollar, e.g., 1,234,567.)
b. What is the value of the company if it decides to repurchase stock instead of retiring its debt? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to the nearest whole dollar, e.g., 1,234,567.)
c. What is the value of the company if the expected bankruptcy costs have a present value of $545,000? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to the nearest whole dollar, e.g., 1,234,567.)

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image

Step: 3

blur-text-image

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

Contemporary Financial Management

Authors: James R Mcguigan, R Charles Moyer, William J Kretlow

10th Edition

978-0324289114, 0324289111

More Books

Students also viewed these Finance questions

Question

What is a verb?

Answered: 1 week ago

Question

What environmental factors influenced achievement?

Answered: 1 week ago

Question

Data points include: state assessments including subgroups

Answered: 1 week ago