Problem 17 10 Personal Taxes, Bankruptcy Costs, and Firm Value Overnight Publishing Company (OPC) has $3 7 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 $3 7 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 $3 7 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 $1,420,000 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 37 percent, and the required rate of return on the firms unlevered equity is 20 percent The personal tax rate on interest income is 25 percent, and there are no taxes on equity distribution Assume 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 (Enter your answer in dollars, not millions of dollars, i e 1,234,567 Do not round intermediate calculations ) Value of OPC $ b What is the value of OPC if it decides to repurchase stock instead of retiring its debt ( Hint Use the equation for the value of a levered firm with personal tax on interest income from the previous problem ) (Enter your answer in dollars, not millions of dollars, i e 1,234,567 Do not round intermediate calculations and round your final answer to the nearest whole dollar amount (e g , 32)) Value of OPC $ c What is the value of OPC if the expected bankruptcy cost have a present value of $520,000 (Do not round intermediate calculations and round your final answer to the nearest whole dollar amount (e g , 32)) Value of OPC unlevered $ Value of OPC levered Problem 17 6 Costs of Financial Distress Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered Both companies will remain in business for one more year The companies' economists agree that the probability of the continuation of the current expansion is 70 percent for the next year, and the probability of a recession is 30 percent If the expansion continues, each firm will generate earnings before interest and taxes (EBIT) of $3 0 million If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $1 4 million Steinberg's debt obligation requires the firm to pay $930,000 at the end of the year Dietrich's debt obligation requires the firm to pay $1 5 million at the end of the year Neither firm pays taxes Assume a discount rate of 12 percent a 1 What is the value today of Steinberg's debt and equity (Enter your answers in dollars, not millions of dollars, i e 1,234,567 Do not round intermediate calculations and round your answers to the nearest whole dollar amount (e g , 32)) Steinberg's Equity value $ Debt value $ a 2 What is the value today of Dietrich's debt and equity (Enter your answers in dollars, not millions of dollars, i e 1,234,567 Do not round intermediate calculations and round your answers to the nearest whole dollar amount (e g , 32)) Dietrich's Equity value $ Debt value $ b Steinbergs CEO recently stated that Steinbergs value should be higher than Dietrichs because the firm has less debt and therefore less bankruptcy risk Do you agree or disagree with this statement Disagree Agree $

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Problem 17-10 Personal Taxes, Bankruptcy Costs, and Firm Value Overnight Publishing Company (OPC) has $3.7 million in excess cash. The firm plans to use this

Problem 17-10 Personal Taxes, Bankruptcy Costs, and Firm Value

Overnight Publishing Company (OPC) has $3.7 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 $3.7 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 $3.7 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 $1,420,000 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 37 percent, and the required rate of return on the firms unlevered equity is 20 percent. The personal tax rate on interest income is 25 percent, and there are no taxes on equity distribution. Assume 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? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations.)

Value of OPC

What is the value of OPC if it decides to repurchase stock instead of retiring its debt? (Hint: Use the equation for the value of a levered firm with personal tax on interest income from the previous problem.) (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount. (e.g., 32))

Value of OPC

c.	What is the value of OPC if the expected bankruptcy cost have a present value of $520,000? (Do not round intermediate calculations and round your final answer to the nearest whole dollar amount. (e.g., 32))

Value of OPC unlevered

Value of OPC levered

Problem 17-6 Costs of Financial Distress

Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered. Both companies will remain in business for one more year. The companies' economists agree that the probability of the continuation of the current expansion is 70 percent for the next year, and the probability of a recession is 30 percent. If the expansion continues, each firm will generate earnings before interest and taxes (EBIT) of $3.0 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $1.4 million. Steinberg's debt obligation requires the firm to pay $930,000 at the end of the year. Dietrich's debt obligation requires the firm to pay $1.5 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 12 percent.

a-1.

What is the value today of Steinberg's debt and equity? (Enter your answers in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your answers to the nearest whole dollar amount. (e.g., 32))

	Steinberg's
Equity value	$
Debt value	$

a-2.

What is the value today of Dietrich's debt and equity? (Enter your answers in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your answers to the nearest whole dollar amount. (e.g., 32))

	Dietrich's
Equity value	$
Debt value	$

Steinbergs CEO recently stated that Steinbergs value should be higher than Dietrichs because the firm has less debt and therefore less bankruptcy risk. Do you agree or disagree with this statement?

Disagree

Agree