1. Management proposes a plan to lower the interest burden for Five Brothers. Five Brothers has one debt investor, Warren Buffett. The proposal to Warren Buffett is to lower the coupon payments of Five Brothers' existing debt contract (Five Brothers has no other debt outstanding). As of now, Five Brothers' existing debt contract promises $140 million of perpetual annual coupon payments to Warren Buffett. Management proposes to reduce the promised perpetual annual coupon payments to $80 million. The proposal does not offer any special compensation payments to Warren Buffett. In both scenarios (no matter if the proposal is accepted or not), the next coupon payment is due in one year from today. If Five Brothers was all-equity financed, its market value would be $3 billion. You should assume perfect capital markets with the exceptions of corporate taxes T_C = 25% and financial distress costs. Depending on Warren Buffet's response to the proposal, the following two scenarios are possible:
   
   Scenario 1 (If the proposal is not accepted by Warren Buffett):
   The existing debt contract stays in place and the present value of future distress cost (PVDC) is 12% of firm value, that is:
                                                PVDC = 0.12 × V_L^No,
   where V_L^No denotes the total firm value today if the proposal is not accepted. At fair market prices, Warren Buffett's debt claim will have a yield to maturity of 7% in this scenario.
   
   Scenario 2 (If the proposal is accepted by Warren Buffett):
   The present value of future distress cost (PVDC) will fall to 2% of firm value, that is:
                                                PVDC = 0.02 × V_L^Yes,  
   where V_L^Yes denotes the total firm value today if the proposal is accepted. At fair market prices, Warren Buffett's debt claim will have a yield to maturity of 5% in this scenario.
   
   For this question, please express all answers in millions of dollars.

 

1. (4 points) What would be the fair market value of Warren Buffett's debt claim in each of the two scenarios?
   
   
   
   
   
   
   
   
   
   
   
   
   
   
    
2. (4 points) What would be the present value of interest tax shields in each of the two scenarios?
   
   
   
   
   
   
   
   
    
3. (6 points) What would be the total firm value in each of the two scenarios? (That is, compute V_L^Noand V_L^Yes)
   
   
   
   
   
   
   
   
   
   
    
4. (4 points) What would be the total equity value in each of the two scenarios?
   
   
   
   
   
   
   
   
   
   
    

(4 points) Suppose Warren Buffet also owns 80% of Five Brothers' equity, and that Five Brothers' capital structure consists of only equity and debt (where the debt is held by Warren Buffet). Should Warren Buffett accept the proposal, that is, is he better off in Scenario 2 than in Scenario 1? Justify your answer.

Answer rating: 100% (QA)

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