Overnight Publishing Company (OPC) has $2.8 million in excess cash. The firm plans to use this...


Overnight Publishing Company (OPC) has $2.8 million in excess cash. The firm plans to use this cash either to retire all of its outstanding debt or to repurchase equity. The firm's debt is held by one institution that is willing to sell it back to OPC for $2.8 million. The institution will not charge OPC any transaction costs. Once OPC becomes an all-equity firm, it will remain unlevered forever. If OPC does not retire the debt, the company will use the $2.8 million in cash to buy back some of its stock on the open market. Repurchasing stock also has no transaction costs. The company will generate $1,330,000 of annual earnings before interest and taxes in perpetuity regardless of its capital structure. The firm immediately pays out all earnings as dividends at the end of each year. OPC is subject to a corporate tax rate of 31 percent, and the required rate of return on the firm's unlevered equity is 19 percent. The personal tax rate on interest income is 20 percent, and there are no taxes on equity distribution. Assume there are no bankruptcy costs.

a. What is the value of OPC if it chooses to retire all of its debt and become an unlevered firm?

b. What is the value of OPC if it decides to repurchase stock instead of retiring its debt?

c. What is the value of OPC if the expected bankruptcy cost have a present value of $430,000?

Capital Structure:

Capital structure represents the combination of debt, equity, and hybrid securities with which a firm maintain its capital. When a firms takes more debt in its capital structure, its value increases because of tax shield on the interest expenses. Sometimes higher debt creates bankruptcy cost which lowers the value of the firm.

Answer and Explanation:

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Value of unlevered firm = {eq}\frac{EBIT(1-t_c)}{Ro} {/eq}

Value of unlevered firm = {eq}\frac{1,330,000(1-0.31)}{0.19} {/eq}

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Capital Structure & the Cost of Capital


Chapter 15 / Lesson 1

In this lesson, we'll define capital and a firm's capital structure. We'll also discuss the costs associated with each component in the capital structure and learn about the concept of risk and return.

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