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The CFO at Optimus Prime, Inc

Business

The CFO at Optimus Prime, Inc. is interested in optimizing their capital structure. Currently, Optimus has $20M in debt with a 7.4% interest rate and the market value of its equity is $93M. Optimus is rated AA-, giving it a roughly 0.14% (yes, that is 0.14%, not 14%!) default probability over the next 10 years. For simplicity, assume that a 10-year horizon is the only thing the CFO is worried about. The CFO also assumes that if the company were to default, it would lose 20% of its total market value. The tax rate is 28%.

 

a. Assuming that Optimus will hold its $20M in debt for the next 10 years as well, what is the value of the tax shield that Optimus gets from holding this debt?

 

 

 

 

b. What is the expected loss from financial distress over the next 10 years? Is it more or less than the tax shield?

 

 

 

 

 

 

c. Now, suppose that Optimus were to double its debt to $40M, and use this to repurchase equity. What is the value of the additional tax shield gained from the increase in debt?

 

 

 

 

 

 

 

d. The CFO estimates that if debt were raised to $40M, the firm would be rated BBB+ and would have a 10-year default probability of 1.62%. What are the new expected costs of financial distress over the next 10 years? Given what you found in part (c), would you recommend that Optimus should increase its debt to $40M?

 

 

 

 

 

 

 

 

 

 

e. The CEO overhears that the CFO is considering a recapitalization, and suggests that maybe Optimus should increase debt to something even higher than $40M. He recommends $60M to get to something close to a 50% debt-to-market value ratio. The CFO is nervous about this proposal because he knows that the probability of default really kicks up when you get to higher debt levels. Suppose that he thinks there is a 10% chance of default in the next 10 years with a $60M level of debt. Is $60M too much debt? Will the firm be worth more with $60M of debt than with $40M?

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