Uses the proceeds to repurchase shares

Assignment Help Financial Management

Reference no: EM132011822

ABC Inc. is an unlevered firm that has EBIT of $2,000,000 and a required return on equity of 10%. The firm has a corporate tax rate of 40% and has estimated that the tax rates for its investors are 25% on stock income and 50% on bond income. Assume the M&M personal tax case holds.

A) Assume that ABC Inc. can issue any level of debt for a fixed before-tax rate of 6%. What will the total value of the firm be if it issues the following levels of debt and uses the proceeds to repurchase shares:

$1,000,000

$5,000,000

$10,000,000

B) Using the same assumptions as in (a), assume the firm estimates that the present value of any financial distress costs would be $4,000,000. The probability of financial distress for each level of debt is :

Amount of Debt Probability of Distress

$0 0%

$1,000,000 7.5%

$5,000,000 25%

$10,000,000 50%

Redo the value calculations from part (a) including the impact of financial distress.

C) What do the results from (a) and (b) indicate about the optimal level of debt in a world with both corporate and personal taxes when financial distress is included in the analysis?

Reference no: EM132011822

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