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Value of unlevered firm

Overnight Publishing Company (OPC) has $2 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 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 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 $1,100,000 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 35 percent, and the required rate of return on the firm's unlevered equity (r0) is 20 percent. The personal tax rate on interest income (TB) is 25 percent and the personal tax rate on equity distributions (TS) is 10 percent. Ignore bankruptcy costs.

What is the value of OPC if it chooses to retire all of its debt and become an unlevered firm?
What is the value of OPC if it decides to repurchase stock instead of retire its debt?

Solution Preview

a. If OPC decides to retire all of its debt, it will become an unlevered firm. The value of an all-equity firm is the present value of the firm's after-tax cash flow to equity holders.

VU = {(EBIT)(1 - TC)(1 - TS)} / r0

where VU = the value of an unlevered firm
EBIT = the firm's annual earnings before interest and taxes
TC = the tax rate on corporate income
TS = the tax rate on equity ...

Solution Summary

The solution explains how to calculate the value of an unlevered firm.

$2.19