Question

Hornqvist, Inc., has debt outstanding with a face value of $4 million. The value of the firm if it were entirely financed by equity would be $18.65 million. The company also has 520,000 shares of stock outstanding that sell at a price of $30 per share. The corporate tax rate is 35 percent. What is the decrease in the value of the company due to expected bankruptcy costs? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, e.g., 1,234,567.)

Financial distress costs           $

Answer 1

Answer :

As per Modigliani and Miller proposition I with taxes -

Value of levered firm = Value of unlevered firm + Debt * tax rate

= $ 18,650,000 + $ 4,000,000 * 0.35

= $ 20,050,000

And, Market value of firm = Market price per share * number of shares + Value of debt

= $ 30 * 520,000 + 4,000,000 = $ 19,600,000

Therefore,

Financial distress costs = $ 20,050,000 - $ 19,600,000 = $ 450,000

Which is the value the firm can't achieve due to financial distress or decrease in value due to expected bankruptcy costs.