Question

Trojan Ltd is an all-equity firm subject to a 30 percent tax rate. Its total market value
is initially $3,500,000. There are 175,000 shares outstanding. The firm announces a
program to issue $1 million worth of bonds at 10 percent interest and to use the
proceeds to buy back common stock. Assume that there is no change in costs of
financial distress and that the debt is perpetual.

Required:
a. What is the value of the tax shield that Trojan Ltd. acquires through the bond
issue?
b. According to Modigliani & Miller, what is the likely increase in market value per
share of the firm after the announcement, i) assuming efficient markets
ii) markets are not efficient?
c. How many shares will the company be able to repurchase?

Answer 1

a:

Cost of bond= 10% ; this is tax deductible expenses

Hence tax shield or tax benefit= 10% * .3= 3% ; this will make effective cost of bond=7%

b:

(i) efficient market: No taxes are considered;

the value of share wont be changinf and will be same

(ii) non efficient market ; Tax benefit will increase the share price:

Hence Value of levered firm = 3.5 + .3*1 = 3.8 million

value of share price= 3.8/.175 =21.71 $

c:

The company will be able to purchase 1million/21.71 = 46061 no of shares