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.

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.

Explain how the presence of corporate taxes would influence Kappa’s restructuring decision.

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.