Question

Overnight Publishing Company (OPC) has $3.4 million in excess cash. The firm plans to use this cash either to retire all of its outstanding debt or to repurchase equity. The firm’s debt is held by one institution that is willing to sell it back to OPC for $3.4 million. The institution will not charge OPC any transaction costs. Once OPC becomes an all-equity firm, it will remain unlevered forever. If OPC does not retire the debt, the company will use the $3.4 million in cash to buy back some of its stock on the open market. Repurchasing stock also has no transaction costs. The company will generate $1,390,000 of annual earnings before interest and taxes in perpetuity regardless of its capital structure. The firm immediately pays out all earnings as dividends at the end of each year. OPC is subject to a corporate tax rate of 24 percent and the required rate of return on the firm’s unlevered equity is 14 percent. The personal tax rate on interest income is 25 percent and there are no taxes on equity distribution. Assume there are no bankruptcy costs. a. What is the value of OPC if it chooses to retire all of its debt and become an unlevered firm? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to the nearest whole number, e.g., 1,234,567.) b. What is the value of OPC if it decides to repurchase stock instead of retiring its debt? (Hint: Use the equation for the value of a levered firm with personal tax on interest income from Problem 9 in the textbook.) (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to the nearest whole number, e.g., 1,234,567.) c. What is the value of OPC if the expected bankruptcy costs have a present value of $700,000? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to the nearest whole number, e.g., 1,234,567.)

Answer 1

Overnight Publishing Company
	Excess Cash	$	3.4	million
	Debt Outstanding	$	3.4	million
	Debt Retiring Cost	$	0
	Corporate Tax Rate		24%
	Re	unlevered	14%
	Personal tax on Interest income		25%
	Tax on Equity Distribution		0%
	Bankrupcy Cost		0
	Option 1		Retiring Debt
	Option 2		Repurchasing Equity
	Option 1: Retiring Debt
	EBIT	$	1390000	Till Perpetuity
	Minus: Interest Cost	$	0
	EBIT		1390000
	Tax (24%)		333600
	Net Income		1056400
	Perpetuity Discussion to Equity Holders	1056400	D
	Return on equity unlevered		14%	r
	Value of Equity		75,45,714	D/r	Answer
	Option 2: Stock repurchase - Please use formula given in Problem 9 if possible
	Value of stock Repurchase	$	3500000
	Stock value remaining	$	40,45,714	Value of Equity minus value of stock repurchase
	Value of Debt	$	3500000
	Debt to total value		0.5
	Cost of Debt		0%
	Cost of capital		7.5%	re*e/(d+e)
	EBIT	$	1390000	Till Perpetuity
	Minus: Interest Cost	$	0
	EBIT		1390000
	Tax (24%)		333600
	Net Income		1056400	D
	Value of Equity		1,40,73,610	D/re
	Option 3: Bankrupcy
	Present Value of the firm		75,45,714
	Present Value of Bankrupcy cost		7,00,000
	Present Value after Bankrupcy Costs	68,45,714