Question 1-3: A company issues junk bonds (high risk bonds) and allows current m

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Question 1-3: A company issues junk bonds (high risk bonds) and allows current management to own all of the equity which creates a capital structure of $400 million in debt and $150 million in equity. Management plans on holding this capital structure constant for 5 years when they will entirely pay off the debt and become an all equity firm. The cost of debt is 14% and the marginal tax rate is 25%. The probability of financial distress in this capital structure is 60% and the after tax cost of distress is $110 million.

I. Which amount is closest to the value of the tax shield of debt for this company?

A. 400 million

B. 144 million

C. 100 million

D. 66 million

E. 48 million

F. Unable to compute this value from the information given.

II. Which amount is closest to the expected cost of bankruptcy?

A. 150 million

B. 110 million

C. 100 million

D. 66 million

E. 48 million

F. Unable to compute this value from the information given.

III. Which of the following are issue(s) that may be created by this capital structure?

1. This larger debt issue may signal to those outside of the firm that the firm has poor future prospects.

2. Firm value may be lower because the managers will be monitored by a debt holder.

3. Firm value may be higher because the monitored by a debt holder

1 only

2 only

3 only

1 & 2 only

None of the above

Explanation / Answer

C. 100 million

B. 110 million

1 & 2 only

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