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# WACC / Optimal debt & capital structure

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A Firm is unleveraged and has a constant EBIT of \$2 million per year. Tax rate is 40% and market value is \$12 million. Debt is being considered to buy back stock. The present value of financial distress costs are \$8 million and the probability of distress would with leverage according to the following: \$2,500,000 of debt -0%, \$5 million -1.25%, \$7.5 million -2.5%, \$10 million -6.25%, \$12.5 million - 12.5%, \$15 million -31.25% and \$ 20 million -75% .

(a) What is the firms WACC at this time?
(b) According to the pure MM with tax model, what is the optimal level of debt?
(c) What is the optimal capital structure when financial distress costs are included ?

#### Solution Preview

Given that,
EBIT=\$2 million
Tax rate=40%
Or, Net income=\$2 million*(1-40%)=\$1,200,000
Market Value of the Firm=\$12 million.
(a) As the growth rate is zero and the market is unleveraged, we have

(b) Let the number of equity is 1 million,
And Interest on debt is 10%
So according to MM Model,
In million \$ \$0 million Debt \$2.5 million debt \$5 million debt \$7.5 ...

#### Solution Summary

The weighted average cost of capital, optimal debt and capital structure is examined.

\$2.49