Personal taxes, Costs of financial distress, and firm value

Overnight Publishing Company $($OPC$)$ has $$2\mathrm{.}5$ 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 $$2\mathrm{.}5$ 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\mathrm{.}5$ 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\mathrm{.}3$ million 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 initially that there are no bankruptcy

costs.

a$)$ What is the value of OPC if it chooses to retire all of its debt and become an

unlevered firm?

b$)$ What is the value of OPC if it decides to repurchase stock instead of retiring its

debt? $($Hint: Remember the formula for the effective tax rate ${}^{**}=1-\frac{(1-{}_c)(1-{}_c)}{(1-{}_i)}$

where ${}_c,{}_e,{}_l$ denote the rates of corporate tax, equity tax and interest tax,

respectively.$)$

$[10\%]$

c$)$ Assume now that expected costs of financial distress have a present value of

$$400,000.$ How does this influence OPC's decision?

$[10\%]$

d$)$ What is the main problem in estimating the effective tax rate of a company?

e$)$ Compare the optimal level of debt of a firm with high expected costs of financial

distress to a firm with virtually no expected costs financial distress. What are

the limits to leverage for the second firm?

f$)$ Give three examples of indirect costs of financial distress and state in which

industries such costs are likely to be important.