Question

Hawar International is a shipping firm with a current share price of $4.77 and 9.6 million shares outstanding. Suppose that Hawar announces plans to lower its corporate taxes by borrowing $8.2 million and repurchasing​ shares, that Hawar pays a corporate tax rate of 25%​ and that shareholders expect the change in debt to be permanent.

a. If the only imperfection is corporate​ taxes, what will be the share price after this​ announcement?

b. Suppose the only imperfections are corporate taxes and financial distress costs. If the share price rises to $4.82 after this​ announcement, what is the PV of financial distress costs Hawar will incur as the result of this new​ debt?

Answer 1

Number of shares repurchased = Repurchased amount/Current share price          
8200000/4.77=   1719077      
Number of shares remaining= 9600000-1719077=   7880923      
Number of remaining shares will be roundup          
Market value of remaining Equity = 4.77*7880923=   37592002.71      
If there is only imperfection of taxes, value of Equity will be increased by present value of interest tax shield          
          
Present value of interest tax shield = Present value of debt * tax rate          
8200000*25%          
2050000          
New value of Equity = Value of Equity Remaining after repurchased + PV of interest tax shield   37592002.71   .+2050000  
39642002.71          
          
Share price = Value of Equity/Remaining shares          
39642002.71   /7880923      
5.030121816          
          
So Share price after repurchase os   $5.03      

B.if the only imperfections are corporate taxes and financial distress costs:          
share price after repurchase=   4.82      

Value of Equity = Equity Remaining after repurchased + PV of interest tax shield-PV of distress cost          
(4.82*7880923)=    37592002.71   .+2050000-X  
37986048.86   -39642002.71   .=-X  
x=   1655953.85      
So PV of financial distress cost is   1655953.85