Overnight Publishing SA (OP) 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 OP for €2 million. The institution will not charge OP any transaction costs. Once OP becomes an all-equity firm, it will remain unlevered forever. If OP does not retire the debt, the company will use the €2 million in cash to buy back some of its equity on the open market.

Repurchasing equity 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. OP is subject to a corporate tax rate of 33.33 per cent, and the required rate of return on the firm’s unlevered equity is 20 per cent. The personal tax rate on interest income is 40 per cent, and there are no taxes on equity distribution. Assume there are no bankruptcy costs.

(a) What is the value of OP if it chooses to retire all of its debt and become an unlevered firm?

(b) What is the value of OP if it decides to repurchase equity instead of retiring its debt?

(c) Assume that expected bankruptcy costs have a present value of €300,000. How does this influence OP’s decision?