Question
An all equity firm with a 10% cost of capital pays a 20% income tax and expects to generate annual perpetual EBIT of $80M with
An all equity firm with a 10% cost of capital pays a 20% income tax and expects to generate annual perpetual EBIT of $80M with 75% probability or $20M. The firm would like to replace $200M of equity with debt. A bank offers the firm this loan amount at 15% annual interest rate. The firm estimates the PV cost of a potential bankruptcy to be $120M. (A) Should the firm accept/reject this loan offer? (Support your answer with actual numbers, that is by how much would firm value increase or decrease after a recapitalization financed with this loan?) (B) How big does the PV cost of a potential bankruptcy have to be to justify forgoing this loan offer?
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