Question

Scenario: Hightower, Inc. plans to announce it will issue $2.0 million of perpetual debt and use the proceeds to repurchase common stock. The bonds will sell at par with a coupon rate of 5%. Hightower, Inc. is currently an all-equity company worth $7.5 million with 400,000 shares of common stock outstanding. After the sale of the bonds, the company will maintain the new capital structure indefinitely. The company currently generates annual pretax earnings of $1.5 million. This level of earnings is expected to remain constant in perpetuity. The tax rate is 35%.

Question: Construct the company's market value balance sheet immediately after the announcement of the debt issue.

Answer 1

VL = VU + TCD

VL = the value of a levered firm

VU = the value of an unlevered firm

TC = the corporate tax rate

D = the value of debt in a firm’s capital structure

PV(Tax Shield) = TCD

= (0.35)($2,000,000)

=$700000

VL = VU + TCD

= $10,000,000 + 700000

VL=10700000

Company's market value balance sheet immediately after the announcement of the debt issue.

Balance Sheet
Old Assets	10000000	Debt
PV(Tax Shield)	700000	Equity	10700000
Total Assets	10700000	Total Assets	10700000