Backcountry Adventures is a Colorado-based outdoor travel agent that operates a series of winter backcountry huts. Currently, the value of the firm (debt + equity) is $3.5 million. But profits will depend on the amount of snowfall: If it is a good year, the firm will be worth $5 million, and if it is a bad year it will be worth $2.5 million. Suppose managers always keep the debt to equity ratio of the firm at 25%, and the debt is riskless.
a. What is the initial amount of debt?
b. Calculate the percentage change in the value of the firm, its equity and its debt once the level of snowfall is revealed, but before the firm adjusts the debt level to achieve its target debt to equity ratio.
c. Calculate the percentage change in the value of outstanding debt once the firm adjusts to its target debt-equity ratio.
d. What does this imply about the riskiness of the firm’s tax shields? Explain.
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