Debt-equity ratio through debt-for-equity exchange

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A firm has a current debt-equity ratio of 2/3. It is worth $10 billion, of which $4 billion is debt. The firm’s overall cost of capital is 12%, and its debt currently pays an (expected) interest rate of 5%. The firm estimates that its debt rating would deteriorate if it were to refinance to a 1/1 debt-equity ratio through a debt-for-equity exchange, so it would have to pay an expected interest rate of 5.5%. The firm is solidly in a 35% corporate income tax bracket. The firm reported net income of $500 million. On a corporate income tax basis only, ignoring all other capital structure–related effects, what would you estimate the value consequences for this firm to be? When would equity holders reap this benefit? That is, calculate the value the instant before it is known and the instant after it is known, and compute the percentage change in value.

Reference no: EM131352351

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