Question

Charisma, Inc., has debt outstanding with a face value of $5.1 million. The value of the firm if it were entirely financed by equity would be $22 million. The company also has 370,000 shares of stock outstanding that sell at a price of $47 per share. The corporate tax rate is 21 percent. What is the decrease in the value of the company due to expected bankruptcy costs

Answer 1

$581,000

Step-by-step explanation:

Given that,

Debt outstanding with a face value = $5.1 million

Value of equity = $22 million

shares of stock outstanding = 370,000

Selling price per share = $47

Corporate tax rate is 21 percent

Value of the levered firm:

= Value of equity + Value of debt

= $22,000,000 + ($5,100,000 × 0.21)

= $22,000,000 + $1,071,000

= $23,071,000

Total market value of the firm:

= Market value of debt + Market value of equity

= $5,100,000 + (370,000 shares × $47)

= $5,100,000 + $17,390,000

= $22,490,000

Bankruptcy costs are under the non-marketed claims and here, one would expect that the value of the levered firm and the total market value of the firm to be the same.

Therefore, the decrease in the value of the company due to expected bankruptcy costs is calculated as follows:

= Value of the levered firm - Total market value of the firm

= $23,071,000 - $22,490,000

= $581,000