Question

Your company has debt outstanding with a face value of 6 million dollars. The value of your firm, if entirely financed by equity, would be $17.85 million. The company also has 350,000 shares of stock in circulation and trading at a price of $38 per share of. The corporate tax rate is 35%. You notice that the value of your enterprise predicted by Modigliani and Miller Proposition I with Taxes differs from the total market value of claims (debt and equity) in circulation. What explains this difference? information costs. expected costs of financial distress. agency costs. Any of these answers may be correct.

Answer 1

The value of your enterprise predicted by Modigliani and Miller Proposition I with Taxes

The value of the levered firm; VL= Value of Unleveraged firm + tax shield

= Value of Unleveraged firm + tax rate * value of debt

= $17,850,000 + 35% *$6,000,000

= $17,850,000 + $2,100,000

= $19,950,000

But total market value of the firm (market value of claim), V= Market value of debt + market value of equity

= $6,000,000 + 350,000 * $38

= $19,300,000

The difference into value = the value of the levered firm - total market value of the firm

OR VL – V = $19,950,000 -$19,300,000

=$650,000

This difference in the value can be explained by bankruptcy costs of the firm or expected costs of financial distress.

Therefore correct answer is option: expected costs of financial distress