Question

20 points eBookPrintReferences Check my work Check My Work button is now disabledItem 3Item 3 20 points Hornqvist, Inc., has debt outstanding with a face value of $4 million. The value of the firm if it were entirely financed by equity would be $18.05 million. The company also has 400,000 shares of stock outstanding that sell at a price of $38 per share. The corporate tax rate is 35 percent. What is the decrease in the value of the company due to expected bankruptcy costs?

(Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, e.g., 1,234,567.)
Financial distress costs $

Answer 1

Financial Distress Costs = $250,000

Step-by-step explanation:

The question is to determine the financial distress costs of Hornqvist Inc as follows:

First we determine the Value of the Levered firm based on the M and M proposition with taxes

Value of Levered Firm= Value of Equity + Value of Debt

Value of levered firm = $18,050,000 + (0.35 x 4,000,000)

= $19,450,000

Secondly, we determine the market value of the firm based on the values of debt and equity as follows

= Value of Equity + Value of Debt

Value of Equity = $400,000 shares x $38 per share = $15,200,000

Value of Debt = $4,000,000

= $15,200,000 + $4,000,000

= $19 ,200,000

Finally, we find the difference between the two figures becomes the financial distress cost

$19,450,000- $19,200,000

= $250,000