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Assume the M&M model with corporate taxes and financial distress holds and that the CAPM is true. Protec Corporations Inc. (PCI) is a corporation financed with debt (B) and equity (S). $10 million of its assets are financed by debt paying an effective annual return of 5%, and the remainder with equity. PCI's earnings are subject to corporate taxes at a rate of 40%. A financial analyst has estimated that if PCI were all-equity firm, it would have a market value of $200 million and that the return on investment in PCI's equity would be 15%.
The financial analyst believes that there are costs of financial distress associated with debt, and s/he estimates the present value of these costs would be:
PVcosts of financial distress = e^2B
Problem a) Calculate the market value of TCI under its leveraged capital structure.
Problem b) Is there an optimal amount of debt for PCI I either case (i) (ii) or both? Justify your answer.
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