Refer again to the Circular File balance sheet in Section 20.2. Suppose that the government suddenly offers to guarantee the $50 principal payment due bondholders next year and also to guarantee the interest payment. (In other words, if firm value falls short of the promised payments, the government will make up the difference.) This offer is a complete surprise to everyone. The government asks nothing in return, and so its offer is cheerfully accepted.

(a) Suppose that the promised interest rate on Circular’s debt is 10 percent. The rate on one-year United States government notes is 8 percent. How will the guarantee affect bond value?

(b) The guarantee does not affect the value of Circular stock. Why? 

(c) How will the value of the firm (debt plus equity) change?

(d) Now suppose that the government offers the same guarantee for new debt issued by Rectangular File Company. Rectangular’s assets are identical to Circular’s, but Rectangular has no existing debt. Rectangular accepts the offer and uses the proceeds of a $50 debt issue to repurchase or retire stock.

Will Rectangular stockholders gain from the opportunity to issue the guaranteed debt? By how much, approximately? (Ignore taxes.)