Question: Bethlehem Steel, one of the oldest and largest steel companies in the United States, is considering the question of whether it has any excess debt capacity. The firm has $ 527 million in market value of debt outstanding, and $ 1.76 billion in market value of equity. The firm has earnings before interest and taxes of $ 131 million, and faces a corporate tax rate of 36%. The company's bonds are rated BBB, and the cost of debt is 8%. At this rating, the firm has a probability of default of 2.30%, and the cost of bankruptcy is expected to be 30% of firm value.
a. Estimate the unlevered value of the firm.
b. Estimate the levered value of the firm, using the adjusted present value approach, at a debt ratio of 50%. At that debt ratio, the firm's bond rating will be CCC, and the probability of default will increase to 46.61%.