fin 3000 set 8
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Hawar International is a shipping firm with a current share price of $ 7.00 and 8 million shares outstanding. Suppose Hawar announces plans to lower its corporate taxes by borrowing $ 22 million
and repurchasing shares.
a. With perfect capital markets, what will the share price be after this announcement?
Suppose that Hawar pays a corporate tax rate of 38 %, and that shareholders expect the change in debt to be permanent.
b. If the only imperfection is corporate taxes, what will the share price be after this announcement?
c. Suppose the only imperfections are corporate taxes and financial distress costs. If the share price rises to $ 7.70 after this announcement, what is the PV of financial distress costs Hawar will incur as
the result of this new debt? Question content area bottom
Part 1
a. With perfect capital markets, what will the share price be after this announcement?
With perfect capital markets, the share price will be $ 7.00 per share, because financial transactions do not create value.
Part 2
Suppose that Hawar pays a corporate tax rate of 38 %, and that shareholders expect the change in debt to be permanent.
b. If the only imperfection is corporate taxes, what will the share price be after this announcement?
To calculate the price per share, use the following formula:
Price per share equals Corporate tax rate times StartFraction Debt Over Shares outstanding EndFraction plus Current share price
With corporate taxes, the value of the firm with leverage will include the present value of the interest tax shield. Therefore,
Price equals 0.38 times StartFraction $ 22 million Over 8 million shares EndFraction plus $ 7.00 equals $ 8.05 per share
If the only imperfection is corporate taxes, the share price will be $8.05 per share.
Part 3
c. Suppose the only imperfections are corporate taxes and financial distress costs. If the share price rises to $ 7.70 after this announcement, what is the PV of financial distress costs Hawar will incur as
the result of this new debt? To calculate the PV, use the following formula:
PV equals left parenthesis Share price with taxes minus New share price right parenthesis times Shares outstanding
Therefore,
PV equals left parenthesis $ 8.05 per share minus $ 7.70 per share right parenthesis times 8 million shares equals $ 2.80 million
If the share price rises to $ 7.70 after this announcement, the PV of financial distress costs Hawar will incur as the result of this new debt will be $2.80 million.
Part 4
Financial transactions do not create value. However, taxes and financial distrees costs do affect the price per share.
The methodology used in this example involves analyzing the impact of financial decisions on share price under different scenarios, considering perfect capital markets as well as imperfections such as
corporate taxes and financial distress costs. Here's a breakdown of the methodology:
Analysis with Perfect Capital Markets:
●
In perfect capital markets, financial transactions do not create value. Therefore, the share price remains unaffected by the announcement of borrowing and share repurchase.
Incorporating Corporate Taxes:
●
Calculate the new share price considering the corporate tax rate and the expected permanent change in debt.
●
Use the formula:
●
Price per share=Corporate tax rate×(DebtShares outstanding)+Current share price
●
Price per share=Corporate tax rate×(
●
Shares outstanding
●
Debt
●
●
)+Current share price
●
This accounts for the present value of the interest tax shield, resulting in a higher share price than in perfect capital markets.
Consideration of Financial Distress Costs:
●
Calculate the present value (PV) of financial distress costs incurred due to the new debt, assuming both corporate taxes and financial distress costs as imperfections.
●
Use the formula:
●
PV=(Share price with taxes−New share price)×Shares outstanding
●
PV=(Share price with taxes−New share price)×Shares outstanding
●
This calculation determines the financial impact of the increase in share price after considering both corporate taxes and expected financial distress costs.
Conclusion:
●
Reiterate that financial transactions do not create value, but the share price is influenced by factors such as taxes and financial distress costs.
The methodology involves applying relevant formulas to calculate the share price under different scenarios, considering the effects of imperfections such as taxes and financial distress costs on the
firm's valuation.
Hawar International is a shipping firm with a current share price of $ 4.50 and 5 million shares outstanding. Suppose Hawar announces plans to lower its corporate taxes by borrowing $ 25 million
and repurchasing shares.
a. With perfect capital markets, what will the share price be after this announcement?
b. Suppose that Hawar pays a corporate tax rate of 35 %, and that shareholders expect the change in
debt to be permanent. If the only imperfection is corporate taxes, what will the share price be after this announcement?
c. Suppose the only imperfections are corporate taxes and financial distress costs. If the share price rises to $ 5.90 after this announcement, what is the PV of financial distress costs Hawar will incur as
the result of this new debt? Question content area bottom
Part 1
a. With perfect capital markets, what will the share price be after this announcement?
With perfect capital markets, the share price will be $
enter your response here per share. (Round to the nearest cent.)
With perfect capital markets, the share price will remain unchanged at $4.50 per share after this announcement.
b. Suppose that Hawar pays a corporate tax rate of 35 %, and that shareholders expect the change in
debt to be permanent. If the only imperfection is corporate taxes, what will the share price be after this announcement?
If the only imperfection is corporate taxes, the share price will be $
enter your response here per share. (Round to the nearest cent.)
If the only imperfection is corporate taxes, the share price will be calculated as follows:
Price per share=Corporate tax rate×(DebtShares outstanding)+Current share price
Price per share=Corporate tax rate×(
Shares outstanding
Debt
)+Current share price
Substituting the given values:
Price per share=0.35×($25 million5 million shares)+$4.50
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Price per share=0.35×(
5 million shares
$25 million
)+$4.50
Price per share=0.35×$5+$4.50
Price per share=0.35×$5+$4.50
Price per share=$1.75+$4.50
Price per share=$1.75+$4.50
Price per share=$6.25
Price per share=$6.25
Therefore, if the only imperfection is corporate taxes, the share price will be $6.25 per share.
c. Suppose the only imperfections are corporate taxes and financial distress costs. If the share price rises to $ 5.90 after this announcement, what is the PV of financial distress costs Hawar will incur as
the result of this new debt? If the share price rises to $ 5.90 after this announcement, the PV of financial distress costs Hawar will incur as the result of this new debt will be $
enter your response here million. (Round to two decimal places.)
To calculate the present value (PV) of financial distress costs incurred due to the new debt, we'll use the formula:
PV=(Share price with taxes−New share price)×Shares outstanding
PV=(Share price with taxes−New share price)×Shares outstanding
Substituting the given values:
PV=($6.25−$5.90)×5 million shares
PV=($6.25−$5.90)×5 million shares
PV=$0.35×5 million shares
PV=$0.35×5 million shares
PV=$1.75 million
PV=$1.75 million
Therefore, if the share price rises to $5.90 after this announcement, the present value (PV) of financial distress costs Hawar will incur as the result of this new debt will be $1.75 million.
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