Consider the following variation of the trade-off model discussed in class. There are three dates
t=0,1/2,1 . At date t=0 , the firm has F0=0.4 of debt outstanding and chooses a new debt amount F
. The outstanding debt comes with the covenant that F0.7 . At date t=1/2 , the firm potentially
learns news about its future cash flows and can potentially change the project (see the
specification of each question below). At date t=1 , cash flows Y are realized. Initially, cash flows
are uniformly distributed on [0,1] . The corporate tax rate is 25% and there is zero recovery upon
default. Suppose that all risk is idiosyncratic and rf=0 . 1a. Suppose first that nothing happens at
date t=1/2 . Compute the optimal debt F that the equity holders choose at t=0 . Is the optimal debt
level higher/lower/equal to the case without the outstanding debt analyzed in class (i.e., when
F0=0 )? What is the logic behind this result? Hint: This part is similar to the case of additional debt
issuance that we covered in class when we talked about the leverage ratchet effect. Note that the
equity holders payoff equals the equity value of E(F) plus the issuance revenue (FF0)P(F) if F>F0
(minus repurchase costs (F0F)P(F) if F<F0 )..
Transparency, Recognition and the role of eSealing - Ildiko Mazar and Koen No...
Consider the following variation of the tradeoff model disc.pdf
1. Consider the following variation of the trade-off model discussed in class. There are three dates
t=0,1/2,1 . At date t=0 , the firm has F0=0.4 of debt outstanding and chooses a new debt amount F
. The outstanding debt comes with the covenant that F0.7 . At date t=1/2 , the firm potentially
learns news about its future cash flows and can potentially change the project (see the
specification of each question below). At date t=1 , cash flows Y are realized. Initially, cash flows
are uniformly distributed on [0,1] . The corporate tax rate is 25% and there is zero recovery upon
default. Suppose that all risk is idiosyncratic and rf=0 . 1a. Suppose first that nothing happens at
date t=1/2 . Compute the optimal debt F that the equity holders choose at t=0 . Is the optimal debt
level higher/lower/equal to the case without the outstanding debt analyzed in class (i.e., when
F0=0 )? What is the logic behind this result? Hint: This part is similar to the case of additional debt
issuance that we covered in class when we talked about the leverage ratchet effect. Note that the
equity holders payoff equals the equity value of E(F) plus the issuance revenue (FF0)P(F) if F>F0
(minus repurchase costs (F0F)P(F) if F<F0 ).
![Consider the following variation of the trade-off model discussed in class. There are three dates
t=0,1/2,1 . At date t=0 , the firm has F0=0.4 of debt outstanding and chooses a new debt amount F
. The outstanding debt comes with the covenant that F0.7 . At date t=1/2 , the firm potentially
learns news about its future cash flows and can potentially change the project (see the
specification of each question below). At date t=1 , cash flows Y are realized. Initially, cash flows
are uniformly distributed on [0,1] . The corporate tax rate is 25% and there is zero recovery upon
default. Suppose that all risk is idiosyncratic and rf=0 . 1a. Suppose first that nothing happens at
date t=1/2 . Compute the optimal debt F that the equity holders choose at t=0 . Is the optimal debt
level higher/lower/equal to the case without the outstanding debt analyzed in class (i.e., when
F0=0 )? What is the logic behind this result? Hint: This part is similar to the case of additional debt
issuance that we covered in class when we talked about the leverage ratchet effect. Note that the
equity holders payoff equals the equity value of E(F) plus the issuance revenue (FF0)P(F) if F>F0
(minus repurchase costs (F0F)P(F) if F<F0 ).](https://image.slidesharecdn.com/considerthefollowingvariationofthetradeoffmodeldisc-230320092216-b3b33680/85/Consider-the-following-variation-of-the-tradeoff-model-disc-pdf-1-320.jpg)
