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Question 4 18 points Save Answer (18 points) Management proposes a plan to lower the interest burden for Five Brothers. Five Brothers has one debt investor, Warren Buffett. The proposal to Warren Buffett is to lower the coupon payments of Five Brothers' existing debt contract (Five Brothers has no other debt outstanding). As of now, Five Brothers' existing debt contract promises $70 million of perpetual annual coupon payments to Warren Buffett. Management proposes to reduce the promised perpetual annual coupon payments to $40 million. The proposal does not offer any special compensation payments to Warren Buffett. Under both scenarios (no matter if the proposal is accepted or not), the next coupon payment is due in one year from today. If Five Brothers was all-equity financed its market value would be $1.2 billion. You should assume perfect capital markets with the exceptions of corporate taxes Tc = 20% and financial distress costs. Depending on Warren Buffet's response to the proposal, the following two scenarios are possible: Scenario 1 (If the proposal is not accepted by Warren Buffett): The existing debt contract stays in place and the present value of future distress cost (PVDC) is 12% of firm value, that is: PVDC = 0.12 * VLNO where VL No denotes the total firm value today if the proposal is not accepted. At fair market prices, Warren Buffett's debt claim will have a yield to maturity of 7% under this scenario. Scenario 2 (If the proposal is accepted by Warren Buffett): The present value of future distress cost (PVDC) will fall to 2% of firm value, that is: PVDC -0.02 V_Yes, where VL Yes denotes the total firm value today if the proposal is accepted. At fair market prices, Warren Buffett's debt claim will have a yield to maturity of 5% under this scenario. For this question, please express all answers in millions of dollars. Be sure to answer all of the parts of the question and clearly label your answer for each part. For example, begin your answer to part A with 'Part A:' A. (3 points) What would be the fair market value of Warren Buffett's debt claim under each of the two scenarios? B. (3 points) What would be the present value of interest tax shields under each of the two scenarios? C. (5 points) What would be the total firm value under each of the two scenarios? (That is, compute V. No and VL Yes) D. (3 points) What would be the total equity value under each of the two scenarios? E. (4 points) Suppose Warren Buffet also owns 50% of Five Brothers' equity, and that Five Brothers' capital structure consists of only equity and debt (where the debt is held by Warren Buffet). Should Warren Buffett accept the proposal, that is, is he better off under Scenario 2 than under Scenario 1? Justify your answer. Question 4 18 points Save Answer (18 points) Management proposes a plan to lower the interest burden for Five Brothers. Five Brothers has one debt investor, Warren Buffett. The proposal to Warren Buffett is to lower the coupon payments of Five Brothers' existing debt contract (Five Brothers has no other debt outstanding). As of now, Five Brothers' existing debt contract promises $70 million of perpetual annual coupon payments to Warren Buffett. Management proposes to reduce the promised perpetual annual coupon payments to $40 million. The proposal does not offer any special compensation payments to Warren Buffett. Under both scenarios (no matter if the proposal is accepted or not), the next coupon payment is due in one year from today. If Five Brothers was all-equity financed its market value would be $1.2 billion. You should assume perfect capital markets with the exceptions of corporate taxes Tc = 20% and financial distress costs. Depending on Warren Buffet's response to the proposal, the following two scenarios are possible: Scenario 1 (If the proposal is not accepted by Warren Buffett): The existing debt contract stays in place and the present value of future distress cost (PVDC) is 12% of firm value, that is: PVDC = 0.12 * VLNO where VL No denotes the total firm value today if the proposal is not accepted. At fair market prices, Warren Buffett's debt claim will have a yield to maturity of 7% under this scenario. Scenario 2 (If the proposal is accepted by Warren Buffett): The present value of future distress cost (PVDC) will fall to 2% of firm value, that is: PVDC -0.02 V_Yes, where VL Yes denotes the total firm value today if the proposal is accepted. At fair market prices, Warren Buffett's debt claim will have a yield to maturity of 5% under this scenario. For this question, please express all answers in millions of dollars. Be sure to answer all of the parts of the question and clearly label your answer for each part. For example, begin your answer to part A with 'Part A:' A. (3 points) What would be the fair market value of Warren Buffett's debt claim under each of the two scenarios? B. (3 points) What would be the present value of interest tax shields under each of the two scenarios? C. (5 points) What would be the total firm value under each of the two scenarios? (That is, compute V. No and VL Yes) D. (3 points) What would be the total equity value under each of the two scenarios? E. (4 points) Suppose Warren Buffet also owns 50% of Five Brothers' equity, and that Five Brothers' capital structure consists of only equity and debt (where the debt is held by Warren Buffet). Should Warren Buffett accept the proposal, that is, is he better off under Scenario 2 than under Scenario 1? Justify your