Reference no: EM132780817
In a one - period world , there is a firm that will have net cash flows of $ 210 million and $ 65 million if the economy is favourable and unfavourable respectively . There are only two states of nature in this case and each state is equally likely to occur . In case of all equity financing, cash flows will be taxed at 33.5 %. However, if the firm uses debt , there will be $ 0.05 reduction in tax payment on every $1.00 of debt financing due to tax advantage of debt. Assume further that investors are risk - neutral and the riskless rate is 10 % per period. Importantly, in case of bankruptcy, the legal fees and other bankruptcy cost will be $ 20 million. Please answer the followings :
a ) What is the value of the firm if is financed by only equity?
b) Assume that the firm will sell a zero - coupon bond worth $ 44 million at maturity (which is the next period in this case, assuming no operational investment change). How much would the firm value increase from issuing this debt?
c) With the debt financing introduced in b), how much would the equity be worth now?
d) Considering the above scenario (as in b) and c)) where the firm uses such debt, how much would be the value of the firm? Does the use of debt increase the value of the firm?
e) Now, consider the case where debt obligation is $ 70 million instead of $ 44 million. Would debt financing still increase the value of the firm? Illustrate with numbers.
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