Your firm is considering issuing one-year debt, and has come up with the following estimates of the value of the interest tax shield and the probability of distress for different levels of debt:

Suppose the firm has a beta of zero, so that the appropriate discount rate for financial distress costs is the risk-free rate of 5%. Which level of debt above is optimal if, in the event of distress, the firm will have distress costs equal to

a. $1 million?

b. $5 million?

c. $27 million?

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PV (interest tax shield, $ million) Probability of Financial Distress 0 0 0% Debt Level ($ million) 40 50 60 70 80 0.76 0.95 1.14 1.33 1.52 0% 1% 2% 7% 90 1.71 16% 31%