What is the optimal capital structure of the firm

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Company is trying to determine its optimal capital structure. The firm is currently all-equity financed and has a total market value of $10 million. Company plans to keep the toal value of capital the same by using the proceeds from debt financing to repurchase outstanding shares of stock. The firm is in the 40% tax bracket. The estimated present value of bankruptcy cost is $6 million and the probability of bankrutpcy is as follows:

Prob. of Bankruptcy @ $2 million of debt = 0.00%

Prob. of Bankruptcy @ $3 million of debt = 5.00%

Prob. of Bankruptcy @ $4 million of debt = 10.00%

Prob. of Bankruptcy @ $5 million of debt = 20.00%

Prob. of Bankruptcy @ $6 million of debt = 30.00%

Prob. of Bankruptcy @ $7 million of debt = 40.00%

Prob. of Bankruptcy @ $8 million of debt = 50.00%

Prob. of Bankruptcy @ $9 million of debt = 60.00%

Based upon the trade-off theory, what is the optimal capital structure of the firm?

A. $2 million of debt financing (a 20% debt-to-capital ratio)

B. $3 million of debt financing (a 30% debt-to-capital ratio)

C. $4 million of debt financing (a 40% debt-to-capital ratio)

D. $5 million of debt financing (a 50% debt-to-capital ratio)

E. $6 million of debt financing (a 60% debt-to-capital ratio)

Reference no: EM132063976

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