Question: NYNEX, the phone utility for the New York Area, has approached you for advice on its capital structure. In 1995, NYNEX had debt outstanding of $ 12.14 billion and equity outstanding of $ 20.55 billion. The firm had earnings before interest and taxes 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 Arated bonds is 1.41%, and the bankruptcy cost is estimated to be 30% of firm value.
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 expect in the optimal leverage?