Question

Dream, Inc., has debt outstanding with a face value of $6 million. The value of the firm if it were entirely financed by equity would be $18.25 million. The company also has 440,000 shares of stock outstanding that sell at a price of $32 per share. The corporate tax rate is 35 percent. What is the decrease in the value of the company due to expected bankruptcy costs?

Answer 1

According to M&M Proposition I with taxes, the value of the levered firm is:

V_L= V_U + t_CB

V_L= $18,250,000 + .35($6,000,000)

V_L= $20,350,000

We can also calculate the market value of the firm by adding the market value of the debt and equity. Using this procedure, the total market value of the firm is:

V = B + S

V = $6,000,000 + 440,000($32)

V = $20,080,000

With no nonmarketed claims, such as bankruptcy costs, we would expect the two values to be the same. The difference is the value of the nonmarketed claims, which are:

V_T = V_M+ V_N

$20,080,000 = $20,350,000 – V_N

V_N = $270,000