Question

Hornqvist, Inc., has debt outstanding with a face value of $6 million. The value of the firm if it were entirely financed by equity would be $18.7 million. The company also has 350,000 shares of stock outstanding that sell at a price of $40 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.)

Answer 1

$800,000

Step-by-step explanation:

we need to first calculate the value of Hornqvist with leverage:

value of the levered company = equity value + (debt's face value x tax rate) = $18,700,000 + ($6,000,000 x 35%) = $20,800,000

now we calculate the market value of Hornqvist:

market value of the company = debt's face value + (total outstanding shares x market price per share) = $6,000,000 + (350,000 x $40) = $20,000,000

finally to calculate the bankruptcy costs:

expected bankruptcy cost = value of levered company - market value = $20,800,000 - $20,000,000 = $800,000