19.9. The following table describes management’s view of Abracadabra Corporation’s future cash flows along with the consensus view of outside analysts.

Cash Flows State of the Economy: Low Average High Management’s beliefs $400 $500 $600 Analysts’ beliefs 300 400 500 Cost of distress 100 150 200 If the analysts can be convinced that management’s beliefs are correct, the firm’s value will increase by $200. Assume that there are no tax or other benefits from debt apart from the information the debt may convey. However, if the promised interest payments exceed the cash flows, the firm will lose $100, $150, or $200 because of financial distress, depending on the state of the economy.
Assuming that management wants to maximize the intrinsic value of the firm, how much debt will the firm take on? Now consider the possibility that management’s incentives place an equal weight on the firm’s intrinsic value and its current value.
How much debt must the firm take on to credibly convince the analysts that their cash flow estimates are wrong? (Hint: Consider management’s incentive to mislead analysts if the analysts’ original projections are correct.)