Question

The following information applies to questions 11 thru 13. Today is December 31, 2019. ABC Inc. generates a steady stream of cash flows and pays out all of its available cash flows in dividends and interest every year in perpetuity. Specifically, the firm pays $1 billion in dividends and $200 million in interest at the end of every year in perpetuity. ABC Inc. has just paid out its annual dividend and interest earlier today. The firm's cost of debt, rD, is 8% and the cost of its levered equity, rE, is 16%. The corporate tax rate is 20%. Calculate the market value of the debt of ABC Inc. as of the end of the day today. Group of answer choices Calculate the market value of the equity of ABC Inc. as of the end of the day today. You may use the information in question 11. Suppose that the managers of ABC Inc. announce a previously unanticipated recapitalization plan where the firm will issue additional equity and use the proceeds to repurchase all of its outstanding debt. How much does the value of ABC Inc. (i.e. the sum of the market value of the debt plus the market value of the equity) fall following the announcement? You may use the information in questions 11 and 12.

Answer 1

Solution:

Using formulas foe PV of perpetutity we calculate as under:

Market Value of Debt = Interest/cost of debt = 200/.08 = $2500 mn

Market Value of Equity = Dividend/cost of equity = 1000/.16 = $6250 mn

Value of the firm (levered), VL = 2500 + 6250 = $8750 mn

Post the recapitalization, the firm will not have any debt, hence it will become unlevered. As the firm is taxed at the corporate tax rate of 20% and the interest expenses if tax deductible, due to recapitalisation, the company will lose the benefit of interest tax shield.

So the value of the company will reduce by the present value of interest tax shields.

Value of Unlevered Firm, VU = Value of Levered firm (VL) - PV of tax shields

VU = 8750 - (200*0.20/0.08) = 8750 - 500 = $8250

Value of the firm reduces by 500 mn.

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