Question

NYNEX, the phone utility for the New York City area, has approached you for advice on its capital structure. In 1995, NYNEX had debt outstanding of $12.14 billion and equity outstanding of $1.7 billion and faced a corporate tax rate of 36%. The beta for the stock is 0.84, and the bonds are rated A - (with a market interest rate of 7.5%). The probability of default for A-rated bonds is 1.41%, and the bankruptcy cost is estimated to be 30% of the firm.

a) estimate the unlevered value of the firm

b)value the firm, if it increases its leverage to 50%. At that debt ratio, its bond rating would be BBB and the probability of default would be 2.30%.

c)Assume now that NYNEX is considering a move into entertainment, which is likely to be both more profitable and riskier than the phone business. What changes would you respect in the optimal leverage?

Answer 1

a) Since EBIT is not given, we have not considered the same.

Current market value of NYNEX = Value of debt + value of equity = (12.14+1.7)

Bankrupcy cost = 30% of value of NYNEX = 0.3*(12.14+1.7)

Expected bankrupcy cost = Probability of default * Bankrupcy cost

The expected bankruptcy cost = 0.0141*(0.3)*(12.14+1.7) = $0.0585 billion.

The tax benefit advantage to debt = 12.14*0.36= $4.37 billion

Hence, the value of the un-levered firm = 12.14+1.7+0.0585-4.37 = $9.528 billion

b) For estimation of the firm value at a leverage of 50% ie. debt of 50, we compute the dollar debt at a 50% debt ratio using the current market values of debt and equity.

Dollar debt at 50% leverage ratio = 0.5*(12.14+1.7) = $6.92 billion

Tax benefits at 50% leverage ratio = 6.92*0.36 = $2.491 billion

Expected bankrupcy cost = Probability of default * Bankrupcy cost

Expected bankruptcy cost = 0.023*(9.528+2.491) = $0.276 billion

Value of the firm = 9.528+2.491-0.276 = $11.74 billion

c) Entertainment which is considered as more profitable and riskier would lead to earnings that are much more volatile as compared previously. Hence, the leverage ratio is expected to be lower since the cost of debt of a riskier firm increases and hence the optimal leverage is expected to be lower.