DFS Corporation is currently an all-equity firm, with assets with a market value of $155 million and 4 million shares outstanding. DFS is considering a leveraged recapitalization to boost its share price. The firm plans to raise a fixed amount of permanent debt (i.e., the outstanding principal will remain constant) and use the proceeds to repurchase shares. DFS pays a 25% corporate tax rate, so one motivation for taking on the debt is to reduce the firm’s tax liability. However, the upfront investment banking fees associated with the recapitalization will be 1% of the amount of debt raised. Adding leverage will also create the possibility of future financial distress or agency costs; shown below are DFS’s estimates for different levels of debt:

a. Based on this information, which level of debt shown above is the best choice for DFS?

b. Estimate the stock price once this transaction is announced.

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Debt amount ($ million) Present value of expected distress and agency costs ($ million) 0 0.0 10 -0.16 20 30 40 50 -1.81 -3.52 -7.41 -11.46