Question

MacKinnon Co. currently has EBIT of $35,000 and is all equity financed. EBIT is expected to stay at this level indefinitely. The firm pays corporate taxes equal to 20% of taxable income. The cost of equity for this firm is 18%.

Suppose the firm has a value of $155,555.56 when it is all equity financed. Now assume the firm issues $71,000 of debt paying interest of 8% per year and uses the proceeds to retire equity. The debt is expected to be permanent.

Value of the firm: 169755.56

value of the equity after the debt issue: 98755.56

Suppose that with the $71,000 of debt and no costs to financial distress the firm has a value of $169,755.56. Suppose, in addition:

1) The debt issue raises the possibility of bankruptcy.

2) The firm has a 11% chance of going bankrupt after 3 years.

3) If it goes bankrupt, it will incur bankruptcy costs of 110,000.

4) The discount rate is 18%.

What is the value of the firm? Enter your answer rounded to two decimal places.

Answer 1

Bankruptcy usually happens when a company has far more debt than it does equity. While debt in a company's capital structure may be a good way to finance its operations, it does come with risks.Bankruptcy costs arise when there is a greater likelihood a company will default on its financial obligations. In other words, when a company decides to increase its debt financing rather than use equity.

In order to avoid financial devastation, companies should take into account the cost of bankruptcy when determining how much debt to take on—even whether they should add to their debt levels at all. The cost of bankruptcy can be calculated by multiplying the probability of bankruptcy by its expected overall cost.

Hence Expected Cost of Bankruptcy = Overall Costs * Probability = 110,000 * 11% = 12,100

We discount the Expeted cost by 3 years and reduce that from the value of the firm

i.e Value of firm = 169755.56 - 12100 / 1.18^3 = 162,391.13

Hence Value of firm is 162,391.13