# Finding the optimal debt value in the given case

Progressive Home Health Care Inc. is a for-profit provider of home health care services in the Pacific Northwest. At present, it has EBIT of $2 million per year, no debt, and a market value of approximately $12 million. Although management is pleased with the good financial condition of Progressive, they are also concerned that the firm might be the target of a potential hostile takeover by a large competitor. Therefore, Progressive is considering issuing debt to buy back shares, the interest on which would be tax deductible (its tax rate is 40 percent). Management recognizes that as the amount of debt increases, both the value of the firm and the risk of financial distress increase. The CFO estimates that the present value of any future financial distress costs is $8 million, and that the probability of distress increases with the amount of debt in the following steps:

Value of debt Probability of financial distress

0 0%

$2,500,000 1%

$5,000,000 2%

$7,500,000 4%

$10,000,000 8%

$12,500,000 16%

$15,000,000 32%

$20,000,000 64%

a. What is Progressive's cost of equity and corporate cost of capital now?

b. According to MM with corporate taxes, what is the optimal level of debt?

c. According to MM with corporate taxes and financial distress, what is the optimal level of debt?

d. Plot the value of Progressive, with and without the costs of financial distress, as a function of the amount of debt. Why do the lines differ in shape?

https://brainmass.com/business/financial-distress-and-bankruptcy/502530

#### Solution Summary

Debt increases the value of a firm. Solution describes the steps to find out the optimal debt value with and without financial distress in the given case.

Finance: Future values, Earnings per share, optimal capital structure.

P4-2 Future value calculation Without referring to tables or to the preprogrammed function on your financial calculator, use the basic formula for future value along with the given interest rate, i, and the number of periods, n, to calculate the future value interest factor in each of the cases shown in the following table. Compare the calculated value to the value in Appendix Table A-1.

P4-3 Future value tables Use the future value interest factors in Appendix Table A-1 in each of the cases shown in the table on the facing page to estimate, to the nearest year, how long it would take an initial deposit, assuming no withdrawals,

a. To double.

b. To quadruple.

P12-4 Breakeven analysis Barry Carter is considering opening a music store. He wants to estimate the number of CDs he must sell to break even. The CDs will be sold for $13.98 each, variable operating costs are $10.48 per CD, and annual fixed

operating costs are $73,500.

a. Find the operating breakeven point in number of CDs.

b. Calculate the total operating costs at the breakeven volume found in part a.

c. If Barry estimates that at a minimum he can sell 2,000 CDs per month, should he go into the music business?

d. How much EBIT will Barry realize if he sells the minimum 2,000 CDs per month noted in part c?

P12-19 EBIT-EPS and capital structure Data-Check is considering two capital structures.

The key information is shown in the following table. Assume a 40%

tax rate.

a. Calculate two EBIT-EPS coordinates for each of the structures by selecting any two EBIT values and finding their associated EPS values.

b. Plot the two capital structures on a set of EBIT-EPS axes.

c. Indicate over what EBIT range, if any, each structure is preferred.

d. Discuss the leverage and risk aspects of each structure.

e. If the firm is fairly certain that its EBIT will exceed $75,000, which structure would you recommend? Why?

P12-21 Integrative-Optimal capital structure Medallion Cooling Systems, Inc., has total assets of $10,000,000, EBIT of $2,000,000, and preferred dividends of $200,000 and is taxed at a rate of 40%. In an effort to determine the optimal

capital structure, the firm has assembled data on the cost of debt, the number of shares of common stock for various levels of indebtedness, and the overall required return on investment:

a. Calculate earnings per share for each level of indebtedness.

b. Use Equation 12.12 and the earnings per share calculated in part a to calculate

a price per share for each level of indebtedness.

c. Choose the optimal capital structure. Justify your choice.