Question

24. Kohwe Corporation plans to finance a new investment with leverage. Kohwe Corporation plans to borrow $46.7 million to finance the new investment. The firm will pay interest only on this loan each​ year, and it will maintain an outstanding balance of $46.7 million on the loan. After making the​ investment, Kohwe expects to earn free cash flows of $9.1 million each year.​ However, due to reduced sales and other financial distress​ costs, Kohwe's expected free cash flows will decline to $8.1 million per year. Kohwe currently has 4.5
a million shares​ outstanding, and it has no other assets or opportunities. Assume that the appropriate discount rate for​ Kohwe's future free cash flows is 7.6% and​ Kohwe's corporate tax rate is 25%. What is​ Kohwe's share price today given the financial distress costs of​ leverage?

Answer 1

It is enumerated in Question that Kohwe Corporation is planning to finance a new investment with leverage and the quantum of finance tantamounts to $ 46.7 million. Since the firm will pay interest only and Loan amounts remains intact , the tax sheild will be available on the loan amount that is the outstanding figure.

As it is stated that due to Debt raising or loan funds, organization is able to generate tax savings . Thus (Corporate Tax Rate * Loan amount ) amounts to tax savings.

Thus, Given data :

Loan amount = $ 46.7 million, Reduced Cash flows = $ 8.1 million per year Outstanding shares = 4.5 million shares Corporate tax rate = 25% , Discount rate = 7.6%

Net Present Value = {Free Cash flows} -   Loan amount + { Loan amount * Corporate tax rate }    { Discount rate }   

= $ 8.1 million - $ 46.7 million + { $ 46.7 million * 0.25 } 0.076

= $ 106.58 million -$ 46.7 million + $ 11.675 million

= $ 71.555 million .

Price of share = Net Present Value / Number of Oustanding shares

= $ 71.555 million / 4.5 million shares

= $ 15.90 per share.