Question

Petr.on corporation's management team is meeting to decide on a new corporate strategy. There are 4 options, each with a different probability of success and total firm value in the event of success, as shown here. Probability of success, A 90% B 76% C 62% D 48%. Firm value if successful (in millions) A 54 B 63 C 72 D 81. Assume that for each strategy, firm value is zero in the event of failure. Also suppose Petron Corporation pay a 25% tax rate on the amount of the final payoff that is paid to equity holders.(A) Assume management pays no tax on payments to, or capital raised from, debt holders(maximizes the value of equity, and in case of ties will choose the strategy. b. Given your answer to (a) show that total combined value of Petron's equity and debts is maximized with a face value of 30 milllion in debt. C. show that if Petron has a 30 million in debt outstanding, shareholders can gain by increasing the face value of debt to 52 million, even though this will reduce the total value of the firm. D. Show that if Petron has 52 million in debt outstanding shareholders will lose by buying back debt to reduce the face value of debt to 30 million, even though that will decrease the total value of the firm.

Answer 1

	Strategy
	A	B	C	D
Probability of success	0.9	0.76	0.62	0,48
Firm Value (if successful)	54	63	72	81
Firm Value (if not successful)	0	0	0	0
Payoff calculation	54x0.9	63x0.76	72x0.62	81x0.48
Payoff after the success of the strategy	48.6	47.88	44.64	38.88
Tax rate	0.25	0.25	0.25	0.25
Tax amount add to equity	12.15	11.97	11.16	9.72
In debt is worth (a)	30	30	30	30
Equity Value Calculation	54-30	63-30	72-30	81-30
Equity Value (b)	24	33	42	51
Tax amount add to equity (as per the question) (c)	12.15	11.97	11.16	9.72
Total value (a+b+c)	66.15	74.97	83.16	90.72
So, answer to part A would be strategy D as it incurs the highest value
In debt is worth	52	52	52	52
Equity Value Calculation	54-52	63-52	72-52	81-52
Equity Value	2	11	20	29
Tax amount add to equity (as per the question) (c)	12.15	11.97	11.16	9.72
Total value (a+b+c)	66.15	74.97	83.16	90.72
So, answer to part A would be strategy D as it incurs the highest value
In debt is worth	30	30	30	30
Equity Value Calculation	54-30	63-30	72-30	81-30
Equity Value	24	33	42	51
Tax amount add to equity (as per the question) (c)	12.15	11.97	11.16	9.72
Total value (a+b+c)	66.15	74.97	83.16	90.72
So, answer to part A would be strategy D as it incurs the highest value