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Suppose a firm has an expected net profit (EBIT) of $1200. The entrepreneur wants to sell the firm and asks an investment bank for financial advice on how to sell the firm so that he can get a maximum price. All agents are risk neutral. The interest rate is 12%. (a) What is the value of the firm if 100% equity is issued? [2p] (b ) What is the value of the firm if debt with face value of $600 is issued and the rest is sold as equity? [3p] Now suppose the firm has to pay corporate taxes. The tax rate is 30%. (c) Compare the value of the firm in (a) and (b) when there is taxation. [4p] (d) Suppose a tax specialist can help the entrepreneur reduce the tax rate to 10%. What is the maximum the entrepreneur is willing to pay for that advice when the firm has $600 face value of debt outstanding? [3p] In subsequent questions, assume there are costs associated with bankruptcy and the probability of bankruptcy is given by D prob(bankruptcy) = 1200 and the costs of bankruptcy are $40. (e) The tax rate is 10%. What capital structure should the investment bank optimally suggest? What is the value of the firm? [6p] Given the tax avoidance strategies of firms, the government changes the tax code. Suppose under the new tax code, the optimal capital structure of the firm has debt with face value of $700. (f) What is the new tax rate? [4p]Suppose a firm has an expected net profit (EBIT) of $1200. The entrepreneur wants to sell the firm and asks an investment bank for financial advice on how to sell the firm so that he can get a maximum price. All agents are risk neutral. The interest rate is 12%. (a) What is the value of the firm if 100% equity is issued? [2p] (b ) What is the value of the firm if debt with face value of $600 is issued and the rest is sold as equity? [3p] Now suppose the firm has to pay corporate taxes. The tax rate is 30%. (c) Compare the value of the firm in (a) and (b) when there is taxation. [4p] (d) Suppose a tax specialist can help the entrepreneur reduce the tax rate to 10%. What is the maximum the entrepreneur is willing to pay for that advice when the firm has $600 face value of debt outstanding? [3p] In subsequent questions, assume there are costs associated with bankruptcy and the probability of bankruptcy is given by D prob(bankruptcy) = 1200 and the costs of bankruptcy are $40. (e) The tax rate is 10%. What capital structure should the investment bank optimally suggest? What is the value of the firm? [6p] Given the tax avoidance strategies of firms, the government changes the tax code. Suppose under the new tax code, the optimal capital structure of the firm has debt with face value of $700. (f) What is the new tax rate? [4p]Company X has zero-coupon debt outstanding with a face value of F > 0 due in exactly one year. This debt does not contain any covenants. The value of the company's assets when the debt comes due will either be 0, 90, or 180 with probabilities 0.2, 0.6, and 0.2, respectively. The current market (and also fair) value of the company's equity is 16. There are no taxes or direct costs of financial distress, all investors are risk neutral, and the risk-free interest rate is zero. The managers of the firm always act in the interests of existing shareholders. When answering each question, state any additional assumptions you may need to make. Show all working/calculations. (a) Determine F, the face value (i.e. promised payment) of the company's debt. [3 marks] Suppose X's managers can choose to costlessly restructure the company's assets so that they will be worth 0 or 180 next year with probabilities 0.7 and 0.3, respectively. (b) Assuming the firm retains its existing assets, graph the expected payoff to X's sharehold- ers as a function of F, i.e. for all feasible face values of debt, 0
