C.H.Inc currently has no debt and expects to earn $10 million in net operating income each...

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C.H.Inc currently has no debt and expects to earn $10 millionin net operating income each year for the foreseeable future. Therequired return on assets for companies of this type is 12.5percent, and the corporate tax rate is 40 percent. There are notaxes on dividends or interest at the personal level. Assume thatthe managers of this company are weighing two capital structurealteration proposals.

Proposal 1: involves borrowing $20 million at an interest rateof 6 percent and using the proceeds to repurchase an equal amountof outstanding stock. With this level of debt, the likelihood thatC.H.Inc will fall into bankruptcy in any given year increases to 15percent, and, if bankruptcy occurs, it will impose direct andindirect costs totaling $12 million.
Proposal 2: involves borrowing $30 million at an interest rateof 8 percent, also using the proceeds to repurchase an equal amountof outstanding stock. With this level of debt, the likelihood ofC.H.Inc falling into bankruptcy in any given year rises to 25percent, and the associated direct and indirect costs ofbankruptcy, if it occurs, increase to $20 million.

For each proposal, calculate the overall value of the firm,assuming that there are no personal taxes on debt or equity income.If necessary, use the industry required return for discountingbankruptcy costs.

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4.3 Ratings (843 Votes)

All financials below are in mn Value of a levered firm VL Value of unlevered firm VU PV Interest tax shield Probability of bankruptcy x PV Bankruptcy costs VU Net operating income x 1 Tax rate See Answer

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C.H.Inc currently has no debt and expects to earn $10 millionin net operating income each year for the foreseeable future. Therequired return on assets for companies of this type is 12.5percent, and the corporate tax rate is 40 percent. There are notaxes on dividends or interest at the personal level. Assume thatthe managers of this company are weighing two capital structurealteration proposals.Proposal 1: involves borrowing $20 million at an interest rateof 6 percent and using the proceeds to repurchase an equal amountof outstanding stock. With this level of debt, the likelihood thatC.H.Inc will fall into bankruptcy in any given year increases to 15percent, and, if bankruptcy occurs, it will impose direct andindirect costs totaling $12 million.Proposal 2: involves borrowing $30 million at an interest rateof 8 percent, also using the proceeds to repurchase an equal amountof outstanding stock. With this level of debt, the likelihood ofC.H.Inc falling into bankruptcy in any given year rises to 25percent, and the associated direct and indirect costs ofbankruptcy, if it occurs, increase to $20 million.For each proposal, calculate the overall value of the firm,assuming that there are no personal taxes on debt or equity income.If necessary, use the industry required return for discountingbankruptcy costs.