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)