Suppose a firm has a profit (EBIT) of $200,000 at t=1. All agents are risk neutral and the interest rate is 25%.

(a) What is the value of the firm with 100% equity? [1p]

(b) What is the value of the firm if it has debt with market value of $100,000 outstanding?

[1p]

Now suppose the firm has to pay corporate taxes. The tax rate is 30%.

(c) Determine the value of the firm in (a) and (b) when there is taxation. [4p]

(d) The firm has debt with market value of $100,000 outstanding. Suppose the government reduces the tax rate from 30% to 20%. What is the value of the firms equity before and after the tax reform? What is the percent change of the stock price with a 10% cut in tax rate? [8p]

Now suppose the firm can go bankrupt and the probability of bankruptcy is given by prob= (D/200,000)2

where D is the face value of debt. The cost of bankruptcy is C=$20,000 and the tax rate is 20%.

(e) What is the optimal amount of debt? What is the value of the firm? [6p]

(f) A firm with debt might face financial distress. What are the costs associated with bankruptcy? What types of firms tend to have higher expected cost of bankruptcy? [4p]