ZZZ is an unlevered company with a current market capitalization of $4 million. The firm is...

ZZZ is an unlevered company with a current market capitalization of $4 million. The firm is considering a leveraged recapitalization that would involve taking on long-term debt and using the proceeds to buy back shares . The company's CFO has put together the following table with regards to the use of various debt levels in the firm’s capital structure:

Amount of Debt	Present value of tax shield	Present value of financial distress costs
$1,000,000	$210,000	$139,500
$1,500,000	$315,000	$175,250
$2,000,000	$420,000	$296,750
$2,500,000	$525,000	$477,000

Based on the tradeoff theory oof capital structure, which of the four debt levels should the CFO choose?

Group of answer choices

$1 million

$1.5 million

$2.0 million

$2.5 million

Solutions

Expert Solution

Correct answer: $1.5 million

Value of Firm = All equity Firm value + PV of tax shield - PV financial distress cost

At optimal level of debt ( optimal capital structure ) the value of firm would be maximum.

Please refer to below spreadsheet for calculation and answer. Cell reference also provided.

Cell reference -

We can see in above table that value of firm is maximum at $1.5 million debt level.

Thus, CFO should choose $1.50 million debt level to obtain optimal capital structure.

jeff jeffy answered 2 years ago

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