Question

Dream, Inc., has debt outstanding with a face value of $X million. The value of the firm would be $18.65 million if it were entirely financed by equity. The company also has 360,000 shares of stock outstanding that sell at $41 per share. The corporate tax rate is 35 percent. The expected bankruptcy cost is 0.64 million. If there is no other market friction like agency cost/benefit, what is X?

Answer 1

Answer :- X = $ 5,000,000

Reason :-

According to M&M Theory with taxes we can calculate the value of the levered firm which is given by:

Vl=Vu + Vd

Vl=18,650,000 + 0.35(x)

Vl=$ 18,65,000 + 0.35x

We can also calculate the total market value of the firm V by adding the debt (Vd) with the equity (Ve)

V= Vd + Ve

V= x + 360,000 * 41

V = 14,760,000 + x

As given expected bankruptcy cost (Vb) of 640,000 then there will be decrease in value of company by 640,000. So the value of firm will be :

Vb= Vl -V

640,000 = 18,650,000 + 0.35x - (14,760,000 + x)

By solving

X = 5,000,000