Slash and Burn Construction Company currently has no debt and expects to earn $12 million in net operating income each year for the foreseeable future. The required return on assets for construction companies of this type is 12.5%, and the corporate tax rate is 40%.
There are no taxes on dividends or interest at the personal level. Slash and Burn calculates that there is a 10% chance the firm will fall into bankruptcy in any given year and that, if bankruptcy does occur, it will impose direct and indirect costs totaling $17 million.
Assume that, in the event of bankruptcy, the firm will reorganize and continue operations indefinitely, with a constant 10% probability of reentering bankruptcy. If necessary, use the industry required return for discounting bankruptcy costs.
1. Compute the present value of bankruptcy costs for Slash and Burn. $
2. Compute the overall value of the firm. $