Question

Overnight Publishing Company (OPC) has $3.8 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 $3.8 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 $3.8 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 $1,430,000 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 23 percent and the required rate of return on the firm’s unlevered equity is 12 percent. The personal tax rate on interest income is 30 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 $800,000? (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

Part 1)

The value of OPC if it chooses to retire all of its debt and become an unlevered firm is determined as below:

Value of OPC (Unlevered Firm) = EBIT*(1-Corporate Tax Rate)/Required Rate of Return on the Firm’s Unlevered Equity

Substituting values in the above formula, we get,

Value of OPC (Unlevered Firm) = 1,430,000*(1-23%)/12% = $9,175,833 (answer for Part 1)

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Part 2)

The value of OPC if it decides to repurchase stock instead of retiring its debt is arrived as below:

Value of OPC (Levered Firm) = Value of Unlevered Firm + [ 1 - (1-Corporate Tax Rate)/(1-Personal Tax Rate on Interest Income)]*Excess Cash

Substituting values in the above formula, we get,

Value of OPC (Levered Firm) = 9,175,833 + [1-(1-23%)/(1-30%)]*3,800,000 = $8,795,833 (answer for Part 2)

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Part 3)

The value of OPC if the expected bankruptcy costs have a present value of $800,000 is calculated as follows:

Value of OPC (Levered Firm) with Bankruptcy = Value of OPC (Levered Firm) - Present Value of Bankruptcy Costs

Substituting values in the above formula, we get,

Value of OPC (Levered Firm) with Bankruptcy = 8,795,833 - 800,000 = $7,995,833 (answer for Part 3)