Reference no: EM133014266

Question - Assume the M&M model with corporate taxes and financial distress holds and that the CAPM is true. Protec Corporations Inc. (PCI) is a corporation financed with debt (B) and equity (S). $10 million of its assets are financed by debt paying an effective annual return of 5%, and the remainder with equity. PCI's earnings are subject to corporate taxes at a rate of 40%. A financial analyst has estimated that if PCI were all-equity firm, it would have a market value of $200 million and that the return on investment in PCI's equity would be 15%. The financial analyst believes that there are costs of financial distress associated with debt, and s/he estimates the present value of these costs would be:

PV costs of financial distress = e2B

(NOTE: both B and PV costs of financial distress are represented in millions of dollars in this function).

Required -

a) Calculate the market value of TCI under its leveraged capital structure.

b) Is there an optimal amount of debt for PCI I either case (i) (ii) or both? Justify your answer.(HINT: Take the derivative of the market value of PCI under a leveraged capital structure, with respect to debt (B), set the derivative equal to zero and solve for B. Is this value optimal? Why or why not?)