Question

"Dream, Inc., has debt outstanding with a face value of $5 million. The value of the firm if it were entirely financed by equity would be $18 million. The company also has 390,000 shares of stock outstanding that sell at a price of $37 per share. The corporate tax rate is 35 percent. What is the decrease in the value of the company due to expected bankruptcy costs?

Answer 1

Answer:$320,000

Step-by-step explanation:

According to Modigliani and Miller theory 1 with taxes we can calculate the value of the levered firm which is given by:

Vl=Vu + tB

Vl=18,000,000 + 0.35(5,000,000)

Vl=$19,750,000

We can also calculate the total market value of the firm Vt by adding the debt (B) with the total equity (SV)

Vt= B + SV

Vt= 5,000,000 + 390,000(37)

Vt= $19,430,000

Then the decrease in the value of the company due to bankruptcy

Vb= Vl -Vt

Vb= 19,750,000 - 19,430,000

Vb=$320,000