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Big Blue Banana (BBB)is a clothing retailer with a current share price of $10.00 and with 25 million shares outstanding.Suppose that Big Blue Banana announces plans to lower its corporate taxes by borrowing $100 million and using the proceeds to repurchase shares.
-Suppose that BBB pays corporate taxes of 21% and that shareholders expect the change in debt to be permanent.Assume that capital markets are perfect except for the existence of corporate taxes and financial distress costs.If the price of BBB's stock rises to $10.29 per share following the announcement,then the present value of BBB's financial distress costs is closest to:

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Quizplus · Accepted Answer

The increase in stock price reflects the tax shield benefit minus the financial distress costs. The tax shield benefit is $100 million * 21% = $21 million. The increase in market value is $0.29 * 25 million shares = $7.25 million. Therefore, the present value of financial distress costs is $21 million - $7.25 million = $13.75 million.

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