In: Finance
Rekall has an EBIT of $250,000 per year forecast in perpetuity. Its cost of equity is 14% and Rekall’s tax rate is 30%. Rekall has debt with a value of $500,000. Rekall is in financial distress. Analysts estimate that Rekall’s indirect costs of distress are 6% and the direct costs of distress are 20% of its value without distress. What are Rekall’s total distress costs?
a. $ 214,000
b. $ 325,000
c. $ 364,000
d. $ 455,000
e. $1,400,000
Unlevered firm means a firm without any debt. With leverage, debt comes in to the capital structure and distress costs start to rise.
Value of a levered firm = Value of unlevered firm + Present value of tax shield - Present value of distress costs
Value of unlevered firm = EBIT*(1-T)/Cost of equity = 250,000*(1-0.30)/0.14 = $1,250,000
Present value of tax shield = Tax rate * Debt = 0.30*500,000 = $150,000
Without distress the value of levered firm = Value of unlevered firm + Present value of tax shield =
$1,250,000+ $150,000 = $1,400,000
As per question the indirect cost of distress is 6% and direct cost of distress is 20% of the value of the firm without distress. So total distress cost is 26% of the value of the firm without distress.
Total distress costs = 0.26*1,400,000 = $364,000
Thus, option c. is correct $364,000.
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