ABC industries has 10 million shares outstanding with a market price of $20 per

Question

ABC industries has 10 million shares outstanding with a market price of $20 per share and no debt. KD has consistently stable earnings, and pays a 35% tax rate. Management plans to borrow $100 Million on a permanent basis through a leveraged recapitalization in which they would use the borrowed funds to repurchase outstanding shares. After the recapitalization, if the price per share of KD becomes $21 the present value of KD's financial distress cost is closest to: A) 12. 5 Million B) 25 Million C) 35 Million D) 5 Million

Explanation / Answer

Answer: Option B: 25 Million.

Calculation:

Value of the firm before taking debt = 10 million * $20 = $200 million

PV of tax shield on debt = 100*0.35 = $35 million

Value of the firm after debt = $200 million + $35 million = $235 million

Value of the firm on the basis of share price = 10 million * $21 = $210 million

Pv of bankruptcy costs = $235 million - $210 million = $25 million.

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