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optimal debt level for unlevered firm and financial distress

A Corporation is an unlevered, zero growth firm with an expected EBIT of $4 million and a corporate tax rate of 40%. Its cost of equity is 10%, and its market value is $22 million. The firm is considering the use of debt financing. They have estimated that the present value of any financial distress costs associated with debt financing would be $10 million, and that the probability of financial distress would increase with the use of debt according to the following schedule:

Value of Debt Prob. Of Distress
$0 0.00%
2,000,000 2.50%
4,000,000 5.00%
6,000,000 10.00%
8,000,000 25.00%
10,000,000 50.00%
12,000,000 75.00%

(a) What is the optimal debt level according to MM with corporate taxes (with no financial distress)?
(b) What is the firm's approximate optimal debt to value ratio when financial distress costs are considered.

Solution Preview

"A Corporation is an unlevered, zero growth firm with an expected EBIT of $4 million and a corporate tax rate of 40%. Its cost of equity is 10%, and its market value is $22 million. The firm is considering the use of debt financing. They have estimated that the present value of any financial distress costs associated with debt financing would be $10 million, and that the probability of financial distress would increase with the use of debt according to the following schedule:
"
(a) What is the optimal debt level according to MM with ...

Solution Summary

This post illustrates the concepts of financial leverage and how the optimal debt level of the firm is affected by leverage and financial distress

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