In a one - period world , there is a firm that will have net cash flows of $ 210 million and $ 65 million if the economy is favourable and unfavourable respectively . There are only two states of nature in this case and each state is equally likely to occur . In case of all equity financing , cash flows will be taxed at 33.5 % . However , if the firm uses debt , there will be $ 0.05 reduction in tax payment on every $ 1.00 of debt financing due to tax advantage of debt . Assume further that investors are risk - neutral and the riskless rate is 10 % per period . Importantly , in case of bankruptcy , the legal fees and other bankruptcy cost will be $ 20 million . 

Answer the followings : 

a ) What is the value of the firm if is financed by only equity ? 

b ) Assume that the firm will sell a zero - coupon bond worth $ 44 million at maturity ( which is the next period in this case , assuming no operational investment change ) . How much would the firm value increase from issuing this debt ? 

c ) With the debt financing introduced in b ) , how much would the equity be worth now ? 

d ) Considering the above scenario ( as in b ) and c ) ) where the firm uses such debt , how much would be the value of the firm ? Does the use of debt increase the value of the firm ? 

e ) Now , consider the case where debt obligation is $ 70 million instead of $ 44 million . Would debt financing still increase the value of the firm ? Illustrate with numbers .

Answer rating: 100% (QA)

a The value of the firm if it is financed by only equity can be calculated as follows Expected cash flows 05 x 210 million 05 x 65 million 1375 millio... View the full answer