Question
Taxes and bankruptcy costs is written: S + B = S0 + TS - PVBC S = levered firm's value of equity B = levered
Taxes and bankruptcy costs is written: S + B = S0 + TS - PVBC
S = levered firm's value of equity
B = levered firm's value of debt
S0 = unlevered firm's value
TS = levered firm's tax shields
PVBC = levered firm's present value of expected bankruptcy costs
rS = cost of levered equity
rB = cost of debt
r0 = cost of unlevered equity
F = face value of debt
*Assume that expected bankruptcy costs are discounted at the unlevered cost of equity
*Cash-flows are not necessarily perpetual
Question: Assume that:
Firms stop their business in one year
Earnings before interest and taxes in one year are expected to be worth EBIT
The corporate tax rate is Tc
The cash-flow to debt holders in one year is expected to be IP + F, where IP is the expected interest payment
The probability that the levered firm defaults in one year is p
Bankruptcy costs are worth BC
Provide a formula for the cost of levered equity rS. The formula has to depend on: S, EBIT, Tc, IP, F, p, BC, rB, and r0 only.
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