Ust Case

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Date Submitted: 09/20/2011 12:26 AM

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1. For each debt level, we computed the EIC at each of the interest rates and we chose the rate, and its corresponding credit rating, whose computed EIC fell into the pre-specified range for that interest rate (which was given on the question sheet). In instances where there were multiple solutions for a particular debt level, the company would choose to issue debt at the lower interest rate and at the better rating. This is because bonds with better ratings have lower probabilities of default, thus lower cost of financial distress and higher expected value for the firm.

Please refer to Exhibit 1 for the calculations.

Interest rate is made up of three components: the real rate, inflation premium, and default risk. One possible reason that there are multiple possible ratings for the $5000 and $6000 debt levels is that as more and more debt is issued, the default risk of the bond (debt) increases. This is especially true given the fact that the higher of the two ratings of the $5000 and 6000 debt levels, BB and B, respectively, are already below investment grade (BBB), indicating high default risk. Difference in ratings could be a result of different market expectations of UST’s future performance. Some investors may be more pessimistic about the economy and UST’s future earnings. They fear that UST might not be able to pay the interest expense, and therefore demand a higher interest rate (lower rating) to compensate for the higher default risk. On the other hand, other investors could be more optimistic (i.e., they think credit spreads will be lower) and they require a lower interest rate, setting the rating higher.

2. a). The average tax rate for the payments to the shareholders would include the taxes paid on dividends and the taxes paid on the stock price gain:

Ts= 0.6*0.5*Ti + (1-0.6)*0.5*Tg

taxes on dividends taxes on capital gains

where Ti= tax rate on personal income (applies to...