Midcap Corporation (MC) will cease to operate in one year. The rm is currently allequity nanced, and has 10 million shares outstanding. In one year,

Midcap Corporation (MC) will cease to operate in one year. The firm is currently all—equity financed, and has 10 million shares outstanding. In one year, MC's projects will generate earnings before interest and taxes of $90 million, $180 million or $225 million with equal probabilities (in the Bad, Medium and Good states respectively). Assume that the physical assets are completely worthless in all three states of the world at that time. The risk is all idiosyncratic, and so all cash flows can be discounted at the same risk free rate of 20%. The corporate tax rate is 20%.

The firm is considering a debt issue whose proceeds will be used to repurchase some of its equity. Two sizes are being considered for this one-year debt contract: a promised payment of$60 million or a promised payment of$120 million. If MC defaults on its debt, it is anticipated that 80% of the available money will be lost to bankruptcy frictions (e.g., legal costs). To simplify calculations, assume that the entire payment on the debt (not just the interest payment) is tax deductible.

(1) Suppose that MC Chooses the debt with the $60 million promised payment. After the debt issue and equity repurchase, what is the value of the debt, the value of the equity, and the total value of the firm? Also, what is the price per share, and how many shares are repurchased?

(2) Suppose instead that MC chooses the debt with the $120 million promised payment. After the debt issue and equity repurchase, what is the value of the debt, the value of the equity, and the total value of the firm? Also, what is the price per share, and how many shares are repurchased?

(3) What is the optimal financing of the firm (no debt, debt with a $60 million face value, or debt with a $120 million face value)? Intuitively explain why .