Consider the model of Credit Risk and Dilution Costs in Freixas and Rochet 2.5.5 based on Bolton and Freixas (2000) where firms have to choose between Bond financing, Equity if suc- Issue and Bank debt. Firms live for two periods and in each period will obtain, y, cessful and zero if unsuccessful. The probability of success in period 2 is 1 for good firms and 0 for bad firms, where each firms knows its own type but lenders cannnot see this type, where the proportion of good firms in period 2 is v. The probability of success in period 1 is uniformly distributed independently of type over the interval [plow, 1]. This probability is observable and represents a frim's credit rating. Under bond financing the firm is liquidated for value A if unsuccessful in period 1. Under equity issue a share ac[0, 1] of any cash flow is given to the investors and under bank debt, if the firms defaults in period 1 then bank will claim all revenues in period 2 at a cost of C for monitoring and renegotiation costs Uninformed risk neutral investors require an expected rate of return of (1+r). = 1, y = 2, C = 1, A=1 and r=0 i.e. 1+r=1. Suppose V= What is the expected profit of a firm with p = if it chooses Bond Finance

Consider the model of Credit Risk and Dilution Costs in Freixas and Rochet 2.5.5 based on Bolton and Freixas (2000) where firms have to choose between Bond financing, Equity if suc- Issue and Bank debt. Firms live for two periods and in each period will obtain, y, cessful and zero if unsuccessful. The probability of success in period 2 is 1 for good firms and 0 for bad firms, where each firms knows its own type but lenders cannnot see this type, where the proportion of good firms in period 2 is v. The probability of success in period 1 is uniformly distributed independently of type over the interval [plow, 1]. This probability is observable and represents a frim's credit rating. Under bond financing the firm is liquidated for value A if unsuccessful in period 1. Under equity issue a share ac[0, 1] of any cash flow is given to the investors and under bank debt, if the firms defaults in period 1 then bank will claim all revenues in period 2 at a cost of C for monitoring and renegotiation costs Uninformed risk neutral investors require an expected rate of return of (1+r). = 1, y = 2, C = 1, A=1 and r=0 i.e. 1+r=1. Suppose V= What is the expected profit of a firm with p = if it chooses Bond Finance

Fundamentals of Financial Management, Concise Edition (with Thomson ONE - Business School Edition, 1 term (6 months) Printed Access Card) (MindTap Course List)

8th Edition

ISBN:9781285065137

Author:Eugene F. Brigham, Joel F. Houston

Publisher:Eugene F. Brigham, Joel F. Houston

Chapter10: The Cost Of Capital

Section: Chapter Questions

Problem 3DQ: Next, we need to calculate MMMs cost of debt. We can use different approaches to estimate it One...

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Next, we need to calculate MMMs cost of debt. We can use different approaches to estimate it One approach is to take the companys interest expense and divide it by total debt (which is the sum of short-term debt and long-term debt). This approach only works if the historical cost of debt equals the yield to maturity in todays market (i.e., if MMMs outstanding bonds are trading at dose to par). This approach may produce misleading estimates in years in which MMM issues a significant amount of new debt. For example, if a company issues a great deal of debt at the end of the year, the full amount of debt will appear on the year-end balance sheet, yet we still may not see a sharp increase in annual interest expense because the debt was outstanding for only a small portion of the entire year. When this situation occurs, the estimated cost of debt will likely understate the true cost of debt. Another approach is to try to find this number in the notes to the companys annual report by accessing the company's home page and its Investor Relations section. Alternatively, you can go to other external sources, such as bondsonline.com, for corporate bond spreads, which can be used to find estimates of the cost of debt. Finally, you can also go to Morningstar.com, which will provide yield to maturity information on the firms various bond issues. A longer-term issues YTM could provide an estimate of the firms current cost of debt to be used in the WACC calculation. Remember that you need the after-tax cost of debt to calculate a firm's WACC, so you will need MMMs tax rate (which has averaged around 30% in recent years). What is your estimate of MMMs after-tax cost of debt?
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