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You own a firm that is going to operate for one year and you want to maximize the current value of the equity. The firm's
You own a firm that is going to operate for one year and you want to maximize the current value of the equity. The firm's before-tax cash flows at the end of the year will be either $30 M (M=million) with probability 35% or $180M with probability of 65%. The tax rate is 35%. You are thinking about issuing debt with a face value of $100 M and paying the proceeds immediately as dividend to yourself. If the firm is not able to repay the debt, it will have to enter bankruptcy and pay bankruptcy costs of $30M. The risk of the firm is perfectly diversifiable, and the risk free rate is equal to zero. How much would debt holders be willing to pay for the firm's debt (that is, how much money are they willing to lend today)? Assume that the Interval Revenue Service considers the difference between the face value of debt ($100 M) and the market value at issue (that you computed in part (a)) to be the interest on debt. What are your expected cash flows (i.e., cash flows to the equity) if you do not issue debt? What are your expected cash flows if you do issue debt? Are you better off issuing debt or keeping the firm all-equity
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