Question

Custer's has bonds outstanding with a face value of $98,000 that are selling at par. It also has 12,000 shares of stock outstanding that are selling for $25.90 a share. The all-equity value of the firm is $398,000. The tax rate is 35 percent. By what amount has the value of the firm been decreased by the expected bankruptcy costs? Assume there are no other claims on the firm.

Answer 1

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

Value of Levered firm = Value of Unlevered firm + Tax * Debt

Value of Levered firm = 398,000 + 0.35 * 98,000

Value of Levered firm = 432,300

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 = Debt + Equity

V = 98,000 + 25.90 * 12,000

V = 408,800

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:

Amount = 432,300 - 408,800

Amount = 23,500