NYNEX, the phone utility for the New York City area, has approached you for advice on its capital structure. In the most recent report, NYNEX had debt outstanding of $12.14 billion and equity outstanding of $20.55 billion. The firm had an EBIT 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 firm value.

(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 expect in the optimal leverage?