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Leverage ratio problem

Handy Inc has debt-to-assets ratio of 40%, tax rate of 35%, and total value of $100 million. W. C. Handy, the CFO, would like to increase the leverage ratio to 42%, and he believes that there will be no change in the bankruptcy cost of the company. How many dollars worth of 12% coupon bonds should the company sell, and buy back its own stock, to achieve the financial restructuring?

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Expert

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Since debt-to-asset ratio is 40% and total value is $100 million, the current debt value is $40 million. Hence current PV of tax benefits is 14.

Hence value of unlevered firm is 100 – 14 = $86 million

Value of levered firm = 86 million + 14.7 million = 100.7 million
Value of debt = 0.42*100.7 = 42.294 million

Hence the value of debt to be issued and value of shares to be bought back is $2.294 million.

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