Optimal debt level-unlevered firm and financial distress

Reference no: EM1344374

A Corporation is unlevered, zero growth firm with expected EBIT of $4 million and corporate tax rate of 40%. Its cost of equity is 10%, and its market value is $22 million. The firm is considering the employ of debt financing. They've estimated that the present value of any financial distress costs associated with the debt financing would be $10 million, and that the probability of financial distress would raise with the employ 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) Find out the optimal debt level according to MM with corporate taxes (with no financial distress)?

b) Find out the firm's approximate optimal debt to value ratio when financial distress costs are considered.

Reference no: EM1344374

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