Jensen Boat Works is an all equity firm that has 340,000 shares of stock outstanding. The company is in the process of borrowing $4 million at 8% interest to repurchase 80,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes?

Question

Quizplus · Accepted Answer

The value of the firm if you ignore taxes can be calculated using the Modigliani-Miller Proposition I without taxes, which states that the value of the leveraged firm (V_L) is equal to the value of the unleveraged firm (V_U). This means that the borrowing does not affect the total value of the firm. Therefore, the value of the firm remains the same before and after the borrowing and share repurchase. Since the firm is borrowing $4 million to repurchase shares and not changing the total value, the firm's value is the sum of its equity and debt. Before the transaction, the firm is all equity, so its value is in its equity. After the transaction, it will have $4 million in debt but the equity value will decrease by the amount used to repurchase the shares. However, the total value (equity + debt) remains unchanged. The problem does not provide information on the initial value of the firm, but it implies that the action of borrowing and repurchasing shares does not change the firm's total value. Given the choices, without specific information on the firm's initial equity value, we cannot calculate the exact value based on the information provided. However, the principle that the firm's value does not change due to financing activities under the Modigliani-Miller Proposition I without taxes leads us to conclude that the firm's value remains constant before and after the transaction. The correct answer would be based on understanding this principle rather than a direct calculation from the given data. My explanation mistakenly attempted to rationalize without acknowledging that the question's setup lacks sufficient data for a direct calculation and inadvertently suggested an incorrect approach to deduce the firm's value. The correct approach should involve recognizing that without the firm's initial value or cash flows, we cannot directly calculate its value solely based on the information provided about the debt transaction.

Jensen Boat Works Is an All Equity Firm That Has