Question

Refer to the Circular File balance sheet. Suppose that the government suddenly offers to guarantee the $50 principal payment due bondholders next year and also to guarantee the interest payment. (In other words, if firm value falls short of the promised payments, the government will make up the difference.) This offer is a complete surprise to everyone. The government asks nothing in return, and so its offer is cheerfully accepted.

a. Suppose that the promised interest rate on Circular’s debt is 10 percent. The rate on one-year United States government notes is 8 percent. How will the guarantee affect bond value?

b. The guarantee does not affect the value of Circular stock. Why? (Note: There could be some effect if the guarantee allows Circular to avoid costs of financial distress or bankruptcy.

c. How will the value of the firm (debt plus equity) change?

Now suppose that the government offers the same guarantee for new debt issued by Rectangular File Company. Rectangular’s assets are identical to Circular’s, but Rectangular has no existing debt. Rectangular accepts the offer and uses the proceeds of a $50 debt issue to repurchase or retire stock.

Will Rectangular stockholders gain from the opportunity to issue the guaranteed debt? By how much, approximately? (Ignore taxes.)

Circular File Company balance sheet
Circular File Company (Market Values)
Asset value	$30	$25	Bonds
		5	Stock
	$30	$30	Firm value

Answer 1

Refer to the below image for the above asked questions, in a detailed way of solution with explanation.

mt@ : The bond value value of the quaranteed risk- free rate: increases to payoff , valued the at present the Reapfirement @ Bond value = ($50 +85)/1008 = $50093 Devorrement trement : The payoffs to Stockholders are on affected. If the firm defaults, its bond holders are paid off, but shareholders get nothing just as before. If the firm does not default payments to Shareholders do not change. - x uirement @ The firm effectively acoquires a new asset, the government guarantee worth $25.93 (the difference between the previous & new bond values). The firm's balance Sheet could be expressed this way: ③ Regjoirement Asset value Government's $30.00 25093 $55093 $50.93 Bonds 5.00 Stock $55.93 & firm value. guarantee 94. pealsoirement a: By issuing 10 percent bonds with $50 face value Rectangular raises $50.93 east (the present of & 55), which is used to reporchase Stock. After the transaction, the market value balance Sheet is the same as circular's. Shareholders have pocketed the $25.93 Value of the government guarant te