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What is the optimal capital structure

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ABC is an unleveraged firm, and it has constant EBIT of $2 million a year. The tax rate is 40% and its 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 increase with leverage according to the following: $2,500,000 of debt-0%, $million-1.25%, $million-2.5%, $10 million-6.25%, 12.5million-12.5%, million-31.25% and $million-75%.

(a) What is firm's cost to equity and weighted average cost of capital at this time?

(b) According to 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?

Reference no: EM13974004

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