Question

Your fim is consldering Isauing one-year cebt, and has come up with the following estimates of the value of the interest tax shield and the probablity of distress for diferent levels of debt: EEB . Suppose the firm has a beta of zero, so that the appropriate discount rate for financial distress costs is the risk-free rate of 5%. Which level of debt above is optimal if in the event of distress, the firm will have distress costs equal to a. $2 million? b. S5 million? c. $25 milion? a. $2 million? Data Table If distress costs are equal to $2 millon, the optimal level of debt is $mllon. (Round to the nearest integer.) Click on the icon located on the fop-nght cormer of the data table below in order to copy its contents into a Debt Level (in 60 million) 70 40 PV (interest tax shield, $ million 0.00 0.76 0.95 1141.33 152 1.71 0% 50 80 90 Probability of Financial Distress 0% 1% 2% 7% 16% 31% Print Done

Answer 1

If the distress cost is $2 million then the optimal level of debt is $40 million ( $2/.05) and this is best because in this case only the probability of Financial Distress is 0.