Question

Hanson currently has EBIT of $250,000 and is all-equity financed. EBIT is expected to stay at this level indefinitely. The firm pays corporate taxes equal to 35% of taxable income. The discount rate for the firm's projects is 10%. What is the market value of the firm? Now assume the firm issues $500,000 of debt that pays interest of 6% per year and uses the proceeds to retire equity. The debt is expected to be permanent. However, the debt raises the possibility of bankruptcy. The firm has a 30% chance of going bankrupt after 3 years. If it does go bankrupt, it will incur bankruptcy cost of $2,000,000. The discount rate is 10%. Should the firm issue the debt?

Answer 1

Market value of the firm:

EBIT = 250,000

NOPAT = EBIT*(1-tax rate) = 250,000*(1-35%) = 162,500

Value of unlevered firm = NOPAT/cost of capital = 162,500/10% = 1,625,000

Value of levered firm = Value of unlevered firm + PV of debt

= 1,625,000 + (35%*500,000) = 1,625,000+175,000 = 1,800,000

Present Value of bankruptcy cost = 2,000,000/(1+10%)^3 = 1,502,629.60

There is a 30% chance that the firm will go bankrupt so cash flow for bankruptcy will be 30%*1,502,629.60 + (70%*0)

= 450,788.88

So, the tax shield gain is 175,000 while bankruptcy cost is 450,788.88.

The company should issue the debt because present value of the bankruptcy cost is more than the present value of the tax shield due to debt, so by issuing debt, the firm will decrease its value.