Question

Trojan Ltd is an all-equity firm subject to a 30 percent tax rate. Its total market value is initially $3,500,000. There are 175,000 shares outstanding. The firm announces a
program to issue $1 million worth of bonds at 10 percent interest and to use the proceeds to buy back common stock. Assume that there is no change in costs of financial distress and that the debt is perpetual.

Required:
a. What is the value of the tax shield that Trojan Ltd. acquires through the bond issue?
b. According to Modigliani & Miller, what is the likely increase in market value per share of the firm after the announcement, i) assuming efficient markets ii) markets are not efficient?
c. How many shares will the company be able to repurchase?

Answer 1

a)Calculation of value of tax shield

Value of tax shield=Amount of debt*tax rate

=$1000,000*30%

=$300,000

b)Increase in market value per share

i)Assuming market is efficient

If market is efficient,value of firm shall be increased by the value of tax shield that is $300,000.thus market value per share shall be increase by

=Increase in value of the firm/No. of shares

=$300,000/175,000

=$1.71

ii)If the market is not efficient,then value of tax shield will not affect the market price of shares.Consequently,there will be no increase in the market value of shares.

c)Current market price per share=$3,500,000/175,000 shares

=$20

i)Assuming market is efficient

Market value per share=Current market price+increase in price due to debt issue

=$20+$1.71

=$21.71

Amount available for repurchase=$1000,000

No. of share that firm can repurchase=$1000,000/$21.71

=46062 shares

ii)When market is not efficient

Market price per share=$20

No. of share that firm can repurchase=$1000,000/$20.00

=50,000 shares