In: Finance
Your firm is considering issuing one-year debt, and has come up with the following estimates of the value of the interest tax shield and the probability of distress for different levels of debt:
Debt Level (in $ million) |
|||||||
0 |
40 |
50 |
60 |
70 |
80 |
90 |
|
PV (interest tax shield, $ million) |
0.00 |
0.76 |
0.95 |
1.14 |
1.33 |
1.52 |
1.71 |
Probability of Financial Distress |
0% |
0% |
1% |
2% |
7% |
16% |
31% |
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. $5 million?
c. $30 million?