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%, $5million-1.25%, $7.5million-2.5%, $10 million-6.25%, 12.5million-12.5%, 15million-31.25% and $20milion-75%.

(a) What is firms 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 in