ABC Company has total common equity outstanding with a market value of $200MM an
ID: 2756921 • Letter: A
Question
ABC Company has total common equity outstanding with a market value of $200MM and total debt outstanding with a market value of $100MM. The treasure has told you that the cost of equity is 32.5% and the pre-tax cost of debt is 7%. If the tax rate is 40%, what is the weighted Average Cost of Capital (WACC) for ABC Company? Since interest on bonds is tax deductible, firms should simply borrow as much capital as they possibly can. Do you agree with this statement? Explain your answer. Explain what bankruptcy costs are and explain the major features of the two types of Federal bankruptcy process.Explanation / Answer
4. Bankruptcy costs are the increased costs of financing with debt instead of equity that result from a higher probability of bankruptcy.Bankruptcy is generally a costly process in itself and not only a transfer of ownership implies that these costs negatively affect the total value of the firm. These costs can be thought of as a financial cost, in the sense that the cost of financing increases because the probability of bankruptcy increases. One way to understand this is to realize that when a firm goes bankrupt investors holding its debt are likely to lose part or all of their investment, and therefore investors require a higher rate of return when investing in bonds of a firm that can easily go bankrupt. This implies that an increase in debt which ends up increasing a firm's bankruptcy probability causes an increase in these bankruptcy costs of debt.
Types of Bankruptcy
The four types of bankruptcy are named for their respective chapters in the United States Bankruptcy Code. The type of bankruptcy that you file depends on several factors, including whether or not you are an individual or part of a corporation.
Chapter 7 is what most people mean when they say, "I'm filing for bankruptcy." This is a liquidation bankruptcy, which means that the trustee sells off all non-exempt assets held by the debtor so that the debts can be repaid to the fullest extent possible. Individuals, corporations and partnerships are all eligible for Chapter 7 bankruptcies. The portion of the debt that can't be repaid through liquidation is discharged. Businesses generally try to avoid Chapter 7, because it is impossible to conduct business operations. Income generated after the bankruptcy filing is not a part of the bankruptcy -- the debtor can keep it.
Chapter 11 is the most complex bankruptcy filing and the one that most troubled businesses file (although some individuals may file it as well). In a Chapter 11 bankruptcy filing, the debtor continues to function, maintains ownership of all assets, and tries to work out a reorganization plan to pay off creditors.
In the past, a business had an almost unlimited amount of time to come up with their reorganization and payment plan. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 imposes a 120-day time limit. If the debtor has not submitted a plan within that period, creditors can submit their own plans.
Chapter 12 is specifically for farm owners. The debtor still owns and controls his assets and works out a repayment plan with the creditors. Chapter 13 is like Chapter 11, but for individuals. The debtor retains control and ownership of assets. He also works out a three to five-year repayment plan. Some portion of the debt may be discharged, depending on the income of the debtor. There are also limits on the amount of debt involved.