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AHN is firm manufacturer. The firm is all-equity financed and has 40 million shares outstanding at...

AHN is firm manufacturer. The firm is all-equity financed and has 40 million shares outstanding at a price of $75 per share. AHN current cost of capital is 7.5%. The firm is considering to buy back $400 million in shares in the open market and to finance the repurchase by issuing bonds. AHN plans to maintain this capital structure indefinitely. At this level of debt, the bonds would be A-rated, and the firm would pay an interest rate of 4.5%.AHN's - marginal corporate tax rate is 25%. With this information answer the following questions.

(iii) Now suppose that the stock price upon announcement of the share repurchase plan equals $77.90. If we assume that the market is efficient, and the firm has not released any other information, what can you infer from this regarding the market’s assessment of AHN’s cost of financial distress, and how would you estimate these costs? Motivate your approach and discuss the inputs in any calculations.

Expert Solution

To calculate the financial distress ,

Find the weighted average cost of debt in distress financial condition.
Subtract the calculated weighted average cost of debt from cost of debt at A-rated.
find the dollar value by multiplying the financial distress cost by existing debt value of financial statement.

By using of WACC , WACC =

Number of share	40000000
Price of share	$75.00
Total capital	$3,000,000,000.00

Value of debt	$400,000,000.00
Number of share buy back	$5,333,333.33

Remaining shares	34666666.67
Value of share capital	$2,600,000,000
weighted value of share capital	0.866666667
weighted value of debt capital	0.133333333

WACC in the first case:

WACC = 0.867*7.5%+ 0.133*4.5%(1-0.25) =6.951%

WACC in second case.

As the market is efficient , the new price of share will be $ 77.90.

Number of share	40000000
Price of share	$77.90
Total capital	$3,116,000,000.00

Value of debt	$400,000,000.00
Number of share buy back	5134788.19

Remaining shares	34865211.81
Value of share capital	$2,716,000,000
weighted value of share capital	0.871630295
weighted value of debt capital	0.128369705

Weighted average cost of debt by use WACC equation

WACC = 0.872 *7.5% + 0.128*W_d *(1-0.25)

=> W_d = 4.285%

Difference from the A- rated debt , 4.5%-4.285% = 0.22%

the dollar value financial distress = 40000000 * 0.22% =$ 85,937.5.

jeff jeffy answered 10 months ago

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