Question

Pacific Inc. has EBIT of $50m per year in perpetuity. The cost of capital of unlevered firm is 10%. Pacific's current market values of debt and equity are $100mm and $260mm respectively. Its corporate tax rate is 30%. What is the decrease in the firm's value due to expected financial distress costs?

Answer 1

$20 mm

Step-by-step explanation:

Calculation for What is the decrease in the firm's value due to expected financial distress costs

First step is to calculate the Value of unlevered firm using this formula

Value of unlevered firm = EBIT x (1 - tax) / Cots of capital

Let plug in the formula

Value of unlevered firm = 50 x (1 - 30%) / 10%

Value of unlevered firm= $350 mm

Now let calculate expected financial distress costs

Using this formula

Market Value of equity = Value of unlevered firm + Tax shield - Debt - Expected Financial Distress

Let plug in the formula

260mm= 350 mm+ 30% x 100mm - 100mm - Expected Financial Distress

260mm= 350 mm+ 30mm - 100mm - Expected Financial Distress

260mm= 280mm-Expected Financial Distress

Expected Financial Distress = $20 mm

Therefore the decrease in the firm's value due to expected financial distress costs will be $20 mm