16.2. Nigel decides he can make zippers at night for one period and will have cash flows next period of

$210 if the economy is favorable, and $66 if the economy is unfavorable. One-third of these proceeds must be paid out in taxes if the firm is all equity financed; however, because of the tax advantage of debt, Nigel saves $0.05 in taxes for every $1.00 of debt financing that he uses.

Assume investors are risk neutral, the riskless rate is 10 percent per period, and the probability of each state is .5. Also assume that if Nigel’s firm goes bankrupt and debt holders take over, the legal fees and other bankruptcy costs total $20.

a. If Nigel organizes his firm as all equity, what will it be worth?

b. Suppose Nigel’s firm sold a zero-coupon bond worth $44 at maturity next period. How much would the firm receive for the debt?

c. With the debt level above, how much would the equity be worth?

d. How much would the firm be worth?

e. Would the firm be worth more if it had a debt obligation of $70 next period?