NYNEX, the phone utility for the New York City area, has approached you for advice on its capital structure. In 1995, NYNEX had debt outstanding of $12.14 billion and equity outstanding of $1.7 billion and faced a corporate tax rate of 36%. The beta for the stock is 0.84, and the bonds are rated A - (with a market interest rate of 7.5%). The probability of default for A-rated bonds is 1.41%, and the bankruptcy cost is estimated to be 30% of the firm.

a) estimate the unlevered value of the firm

b)value the firm, if it increases its leverage to 50%. At that debt ratio, its bond rating would be BBB and the probability of default would be 2.30%.

c)Assume now that NYNEX is considering a move into entertainment, which is likely to be both more profitable and riskier than the phone business. What changes would you respect in the optimal leverage?