Explore BrainMass
Share

optimal debt level for unlevered firm and financial distress

This content was STOLEN from BrainMass.com - View the original, and get the already-completed solution here!

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.

© BrainMass Inc. brainmass.com October 24, 2018, 11:31 pm ad1c9bdddf
https://brainmass.com/business/financial-distress-and-bankruptcy/optimal-debt-level-for-unlevered-firm-and-financial-distress-196235

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

$2.19
See Also This Related BrainMass Solution

According to MM with corporate taxes and with and without financial distress, what is the optimal level of debt?

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?

View Full Posting Details