An unlevered firm, Marshall Inc., has a constant EBIT of $1,500,000 per year in perpetuity. It is considering the use of some debt financing to repurchase shares. Based on the PV of bankruptcy costs of $2,500,000, the following schedule has been developed:

Value of Debt Probability of financial distress

$200,000                                         0.00%

600,000 1.00%

1,000,000                                         2.00%

2,000,000                                        7.00%

3,000,000                                       15.00%

4,000,000                                       40.00%

5,000,000 65.00%

The current cost of equity is 18%, and the tax rate is 40%. Assume that the company can borrow at a cost of 10%.

a) What is Marshall’s market value and the WACC before any debt is taken on?

b) In M&M’s case (world) II, what is Marshall’s optimal level of debt?

c) What is the optimal capital structure when financial distress costs are included?

d) Compute the WACC at the optimal capital structure determined in part (c).