UST is an all-equity tobacco firm. It currently has 185.5 million shares outstanding, and its current stock price is $34.88/share. An investment banker pitched the idea of UST raising permanent debt of $500 million, and using the proceeds to repurchase its shares. The bonds are expected to receive a credit rating of AA by S&P. Given the fiscally conservative culture of UST (e.g., have not used any debt financing in the past), you are interested in estimating the financial distress costs associated with the debt issue. You obtained two important pieces of information: 

(a) Historical default rate of bonds that are rated AA is lower than 1%, and

 (b) Direct and indirect costs are estimated to be in the order of 20% of the value of the firm.

Based on these inputs, what is your estimate of the present value of financial distress costs associated with the $500 million permanent debt issue?

Answer rating: 100% (QA)

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