The Southwind Company currently has no debt. A research group of internal staff has been assigned the job of determining the optimal capital structure. The research group, decided to carry out the analysis using the MM framework with financial distress cost. The following data are collected:
EBIT = $4 million per year, in perpetuity
Tax rate = 40%
Dividend payout ratio = 100%
Current cost of equity = 12%
The research group estimated the present value of financial distress costs at $8 million. Additionally, they estimated the following probabilities of financial distress:
Debt level (million) $0 $4 $8 $12
Probability of financial distress 0 0.05 0.10 0.47
problem:
Determine the optimal debt level that maximizes the value of the firm and describe why the optimal debt level is not at a higher or lower debt level.