Problem: A Firm is unleveraged and has a constant EBIT of $2 million per year. Tax rate is 40% and market value is $12 million. Debt is being considered to buy back stock. The present value of financial distress costs are $8 million and the probability of distress would with leverage according to the following: $2,500,000 of debt -0%, $5 million -1.25%, $7.5 million -2.5%, $10 million -6.25%, $12.5 million - 12.5%, $15 million -31.25% and $ 20 million -75% .
(a) What is the firms WACC at this time?
(b) According to the pure MM with tax model, what is the optimal level of debt?
(c) What is the optimal capital structure when financial distress costs are included ?