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 $16 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. Assume that the managers of Slash and Burn Construction Company are weighing two capital structure alteration proposals, as follows.
Proposal 1: Borrow $18 million at an interest rate of 6% and use 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%, and if bankruptcy occurs then it will impose direct and indirect costs totaling $14 million.
Proposal 2: Borrow $28 million at an interest rate of 8% and use 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%, and the associated direct and indirect costs of bankruptcy, should it occur, increase to $18 million.
For each proposal, calculate the present value of the interest tax shields, bankruptcy costs and the overall value of the firm, assuming there are no personal taxes on debt or equity income.
Proposal 1:
PVts =
PVbr=
V=
Proposal 2:
PVts=
PVbr=
V=