Slash and Burn Construction Company currently has no debt and expects to earn $10 million in net operating income each year, for the foreseeable future. The required return on assets for construction companies of this type is 12.5 percent, and the corporate tax rate is 40 percent. There are no taxes on dividends or interest at the personal level. Slash and Burn calculates that there is a 10 percent chance that the firm will fall into bankruptcy in any given year.
If bankruptcy does occur, it will impose directand indirect costs, totaling $12 million. If necessary, use the industry required return for discounting bankruptcy costs.
a. Compute the present value of bankruptcy costs for Slash and Burn.
b. Compute the overall value of the firm.
c. Recalculate the value of the company, assuming that the firm's shareholders face a 25 percent personal tax rate on equity income.