Marbel is a large all-equity retailer. The firm has just unexpectedly announced
ID: 2806346 • Letter: M
Question
Marbel is a large all-equity retailer. The firm has just unexpectedly announced that it will
borrow $200M and will use the proceeds to buy back shares. The firm will keep this amount
of debt permanently. The corporate tax rate is 25%. The firm has 30M shares outstanding
that traded for $13 in the stock market right before the announcement. At the announcement
of this restructuring, the stock price increased to $14 per share. Assume that the only market
imperfections are corporate taxes and financial distress costs.
Given the announcement reaction, what is the market’s estimate for the present value of
financial distress costs PV (F DC)?
(A) $ 10M
(B) $ 20M
(C) $ 25M
(D) $ 30M
Explanation / Answer
This can be solved in 2 parts :
Firstly the overall advantage to marbel would be 25% of 200M i.e = $50m ( This is the 25% corporate tax advantage on the debt which is permanent and hence equal to an perpetuity stream).
Secondly, the advantage due to the share price appreciation = ($14-$13)*30m shares = $30m
now overall Advantage = Share price Advantage + financial distress component( due to Corporate taxes and F.D costs)
50 = 30 + financial distress costs( assuming that they are independent)
Thus, PV of Financial distress costs = $50m - $30m = $20m(Option (B))