Slash and Burn Construction Company currently has no debt and expects to earn $10 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 percent, and the corporate tax rate is 40 percent. There are no taxes on dividends or interest at the personal level. Slash and Burn calculates that there is a 10 percent chance that the firm will fall into bankruptcy in any given year. If bankruptcy does occur, it will impose direct and indirect costs, totaling $12 million.
If necessary, use the industry required return for discounting bankruptcy costs. Assume that the managers of this company are weighing two capital structure alteration proposals.
Proposal 1 involves borrowing $20 million, at an interest rate of 6 percent, and using the proceeds to repurchase an equal amount of outstanding stock. With this level of debt, the likelihood that Slash and Burn will fall into bankruptcy in any given year increases to 15 percent. If bankruptcy occurs, it will impose direct and indirect costs, totaling $12 million.
Proposal 2 involves borrowing $30 million, at an interest rate of 8 percent, and also using the proceeds to repurchase an equal amount of outstanding stock. With this level of debt, the likelihood of Slash and Burn falling into bankruptcy in any given year rises to 25 percent. The associated direct and indirect costs of bankruptcy, if it occurs, increase to $20 million. For each proposal, calculate both the present value of the interest tax shields and the overall value of the firm, assuming that there are no personal taxes on debt or on equity income.