ABC Inc. is an unlevered firm that has EBIT of $2,000,000 and a required return on equity of 10%. The firm has a corporate tax rate of 40% and has estimated that the tax rates for its investors are 25% on stock income and 50% on bond income. Assume the M&M personal tax case holds.
A) Assume that ABC Inc. can issue any level of debt for a fixed before-tax rate of 6%. What will the total value of the firm be if it issues the following levels of debt and uses the proceeds to repurchase shares:
$1,000,000
$5,000,000
$10,000,000
B) Using the same assumptions as in (a), assume the firm estimates that the present value of any financial distress costs would be $4,000,000. The probability of financial distress for each level of debt is :
Amount of Debt Probability of Distress
$0 0%
$1,000,000 7.5%
$5,000,000 25%
$10,000,000 50%
Redo the value calculations from part (a) including the impact of financial distress.
C) What do the results from (a) and (b) indicate about the optimal level of debt in a world with both corporate and personal taxes when financial distress is included in the analysis?