Pennsylvania steel, one of the largest steel companies in the united States, is

Question

Pennsylvania steel, one of the largest steel companies in the united States, is considering whether it has any excess debt capacity. The company has $527 million in market value of debt outstanding and $1.76 billion of market value o equity. The company has EBIT of $131 Million and faces a corporate tax rate of 36%. The company's bonds are rated BBB, and the cost of debt is 8%. At this rating the company has probability of default of 2.30%, and the cost of bankruptcy is estimated to be 30% of firm value.

A. Estimate the unlevered value of firm.

B. Estimate the levered value of the firm using the APV approach, at a debt ratio of 50%. at that debt ratio, the firm's bond rating will be CCC, and the probability of default will increase to 30%.

Explanation / Answer

A. Unlevered value of firm

Current market value of the firm ($ 527 million + $ 1760 million) =        $ 2287.00 million
- tax benefit on current debt ( $ 527 * 0.36)                                    = $ 189.72 million
+ expected bankrupcy cost ( 2287* 0.30* 2.30%)                             = $   15.78 million
unlevered value firm                                                                    = $ 2113.06 million

B. levered value of the firm using APV approach at a debt ratio of 50%

Current market value of the firm ($ 527 million + $ 1760 million) =        $ 2287.00 million
Debt ( 2287*50%)                                                                  =       $ 1143.50 million
Tax Benefit on debt = (1143.50* 36%)                                  =       $ 411.66 million
expected bankrupcy cost = ( 1143.50* 0.30)                         =       $ 343.05 million

Levered value of firm ( 2287.00- 343.05+411.66)    =   $ 2355.61 million

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