Question

Kong Ltd is a home appliance manufacturer listed on the local stock exchange. The company has no debt but has 100 million shares with a current price $10 per share. The company would like to change its capital structure by borrowing $300 million and repurchasing shares. The restructure plan is announced to the market and shareholders expect the change in debt to be permanent

(i). Assume the market is perfect so all the assumptions of Modigliani and Miller (MM) theorey hold. Calculate the value of the firm and the value of equity after the proposed share repurchase.

(ii). Assume the market is imperfect and the only imperfections are corporate taxes and financial distress costs. Kong pays corporate taxes of 40%. If the share price of Kong Ltd increases to $10.6 immediately after the announcement of the capital restructure plan, what is the present value of financial distress costs Kong will incur as the result of the debt?

Answer 1

Current Scenario -

Debt = 0
Equity = 100 million shares * $10 = $1000 million

Part 1 -

Modigliani and Miller theory says that value of the company remains same irrespective of the capital structure.

So after raising debt and repurchasing shares -
Debt = 300 million
Equity = 700 million (70 million shares outstanding)

So that total value remains 1000 million.


Part 2 -

Market imperfections take value of firm to - 100 million shares * $10.6 = $1060 million
Out of the above value $300 million will get converted into debts.
Remaining value of equity = 1060 - 300 = $760 million

Extra value added by the market imperfection = 1060 - 1000 = $60 million

Now remember, why the value of the firm has gone up, because now the interest paid on the debt is a pre-tax expense and hence results into higher value for the firm. But it also results into financial distress for the firm so additional cost. Distress cost would be difference of PV of tax benefit of interest and actual increase in the value of the firm.

Assume cost of debt is Kd.
Total Interest Cost = 300*Kd
Let financial distress cost = x
Tax Saved on this amount = 300*Kd*40%
Total value of tax saved by interest = Total NPV of this interest cost = (300*Kd*40%)/Kd = $120 million

Hence , Financial Distress Cost = Tax Benefit of Interest - Actual Increase in the value
= 120 - 60
= 60 million

Total Financial Distress Cost would be = $60 million