Question

Backcountry Adventures is a​ Colorado-based outdoor travel agent that operates a series of backcountry huts.​ Currently, the value of the firm is

$3.8

million. But profits will depend on the amount of​ snowfall: If it is a good​ year, the firm will be worth

$5.4

​million, and if it is a bad year it will be worth

$2.4

million. Suppose managers always keep the debt to equity ratio of the firm at

30%​,

and the debt is riskless.     

a. What is the initial amount of​ debt?

b. Calculate the percentage change in the value of the​ firm, its equity and its debt once the level of snowfall is​ revealed, but before the firm adjusts the debt level to achieve its target debt to equity ratio.

c. Calculate the percentage change in the value of outstanding debt once the firm adjusts to its target​ debt-equity ratio.

d. What does this imply about the riskiness of the​ firm's tax shields. Explain.

Answer 1

Part a

initial amount of debt = 3.8*30% = 1.14 million

Part b

if its a good year

value of firm = 5.4 million

percentage change in the value of firm = (5.4-3.8)/3.8 = 42.10%

Debt = 1.14 million

equity - 4.26 million

If its a bad year

value of firm = 2.4 million

percentage change in the value of firm = (2.4-3.8)/3.8 = 36.84%

Debt = 1.14 million

equity - 1.26 million

Part c

if its a good year

value of firm = 5.4 million

Debt = 5.4*30% = 1.62 million

% change in debt = (1.62-1.14)/1.14 = 42.10%

If its a bad year

value of firm = 2.4 million

Debt = 2.4*30% = 0.72  million

% change in debt = (0.72-1.14)/1.14 = 36.84%

Part d

What does this imply about the riskiness of the​ firm's tax shields.

The higher the debt in the company, the more tax saving the company can do.

in the current scenario, the debt is riskless hence the company should invest more amount in debt than in equity to save taxes which will increase the overall earnings/profit of the company.