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Dream, 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 $18.25 million. The company also has 440,000 shares of stock outstanding that sell at a price of $32 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 :

Tundexi

The decrease in the value of the company due to expected bankruptcy costs is $270,000.

The formula for value of the levered firm according to  M&M Proposition I with taxes is {VL= VU + tCB}

VL= $18,250,000 + 0.35*($6,000,000)

VL= $18,250,000 + $2,100,000

VL= $20,350,000

Generally, the market value of the firm equals market value of the debt and market value of the equity.

  • The formula for the total market value of the firm is V = B + S

V = $6,000,000 + 440,000*($32 per share)

V = $20,080,000

  • The decrease in the value of the company due to expected bankruptcy costs will be derived as follows:

VT = VM+ VN

$20,080,000 = $20,350,000 – VN

– VN = $20,080,000 - $20,350,000

VN = $270,000

Therefore, the decrease in the value of the company due to expected bankruptcy costs is $270,000.

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