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Finding the optimal debt value with financial distress

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:

Probability
of financial
Value of debt 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?

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Solution Preview

Please refer attached file for tables and graph.

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

EBIT =$2 million
Tax Rate = T = 40%
Interest = I = 0 Debt free
Market Value of firm=$12 million
Earnings after tax and interest = (EBIT-I)*(1-T) = $1.20 million

Corporate cost of capital=Earnings after tax and ...

Solution Summary

Tax shield on 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.

$2.19