Company A is initially unlevered, and the market value of its equity is $500million. The...
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Company A is initially unlevered, and the market value of its equity is $500million. The company plans to change its capital structure to include $200 million debt. It plans to issue perpetual debt and once it has chosen an amount of debt it plans to maintain this level (dollar amount) of debt forever. The corporate tax rate is 30%. (A) First consider only the tax benefits of debt. What do you expect the increase in the value of the firm to be if the firm added $200 million of perpetual debt? (B) Now consider also the present value of expected bankruptcy costs (expected financial distress costs) given the following information: The probability of bankruptcy for this firm with $200 million of perpetual debt estimated to be 0.10. This estimated probability is a steady-state probability, such that the probability that the firm will go bankrupt in the current year (given that it has not become bankrupt in prior years) has been estimated to be the same 0.10, year after year. The return on the debt is given to be 7.5%. The cost of bankruptcy once it happens is estimated to be $50 million. What would be the value of the firm with a leverage of $200 debt? Should the firm take on that debt of $200 million or stay unlevered?
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