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The financial distress costs of leverage

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Reference no: EM132003382

Kohwe Corporation plans to issue equity to raise $60 million to finance a new investment. After making the investment, Kohwe expects to earn free cash flows of $9 million each year. Kohwe currently has 5 million shares outstanding, and it has no other assets or opportunities. Suppose the appropriate discount rate for Kohwe's future free cash flows is 8%, and the only capital market imperfections are corporate taxes and financial distress costs.

a. What is the NPV of Kohwe's investment?

b. What is Kohwe's share price today?

Suppose Kohwe borrows the $60 million instead. The firm will pay interest only on this loan each year, and it will maintain an outstanding balance of $60 million on the loan. Suppose that Kohwe's corporate tax rate is 40%?, and expected free cash flows are still $9 million each year.

c. What is Kohwe's share price today if the investment is financed with debt?

Now suppose that with leverage, Kohwe's expected free cash flows will decline to $8 million per year due to reduced sales and other financial distress costs. Assume that the appropriate discount rate for Kohwe's future free cash flows is still 8%.

d. What is Kohwe's share price today given the financial distress costs of leverage?

Reference no: EM132003382

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