# Question: Consider the setting of Problem 21 and suppose Petron Corp

Consider the setting of Problem 21, and suppose Petron Corp. has debt with a face value of $40 million outstanding. For simplicity assume all risk is idiosyncratic, the risk-free interest rate is zero, and there are no taxes.

a. What is the expected value of equity, assuming Petron will choose the strategy that maximizes the value of its equity? What is the total expected value of the firm?

b. Suppose Petron issues equity and buys back its debt, reducing the debt’s face value to $5 million. If it does so, what strategy will it choose after the transaction? Will the total value of the firm increase?

c. Suppose you are a debt holder, deciding whether to sell your debt back to the firm. If you expect the firm to reduce its debt to $5 million, what price would you demand to sell your debt?

d. Based on your answer to (c), how much will Petron need to raise from equity holders in order to buy back the debt?

e. How much will equity holders gain or lose by recapitalizing to reduce leverage? How much will debt holders gain or lose? Would you expect Petron’s management to choose to reduce its leverage?

a. What is the expected value of equity, assuming Petron will choose the strategy that maximizes the value of its equity? What is the total expected value of the firm?

b. Suppose Petron issues equity and buys back its debt, reducing the debt’s face value to $5 million. If it does so, what strategy will it choose after the transaction? Will the total value of the firm increase?

c. Suppose you are a debt holder, deciding whether to sell your debt back to the firm. If you expect the firm to reduce its debt to $5 million, what price would you demand to sell your debt?

d. Based on your answer to (c), how much will Petron need to raise from equity holders in order to buy back the debt?

e. How much will equity holders gain or lose by recapitalizing to reduce leverage? How much will debt holders gain or lose? Would you expect Petron’s management to choose to reduce its leverage?

**View Solution:**## Answer to relevant Questions

Consider the setting of Problems 21 and 22, and suppose Petron Corp. must pay a 25% tax rate on the amount of the final payoff that is paid to equity holders. It pays no tax on payments to, or capital raised from, debt ...According to the managerial entrenchment theory, managers choose capital structures so as to preserve their control of the firm. On the one hand, debt is costly for managers because they risk losing control in the event of ...Raviv Industries has $100 million in cash that it can use for a share repurchase. Suppose instead Raviv invests the funds in an account paying 10% interest for one year.a. If the corporate tax rate is 40%, how much ...Suppose Goodyear Tire and Rubber Company has an equity cost of capital of 8.5%, a debt cost of capital of 7%, a marginal corporate tax rate of 35%, and a debt-equity ratio of 2.6. Suppose Goodyear maintains a constant ...Tybo Corporation adjusts its debt so that its interest expenses are 20% of its free cash flow. Tybo is considering an expansion that will generate free cash flows of $2.5 million this year and is expected to grow at a rate ...Post your question