Old School Corporation, an all equity firm has current EBIT of $1,000,000. It expects EBIT to increase at 5% per year forever. The corporate tax rate is 40%, and cost of unlevered equity is 12%. LTL is considering replacing some of the equity with perpetual debt. It has been determined that risk of bankruptcy is a function of amount of debt. PV of bankruptcy related costs will be $5,000,000. LTL is considering the following debt levels. 

a. Determine the optimal level of debt, and the value of the firm at that level. 

b. If personal tax rate on stock income is 25%, and the personal tax rate on bond income is 43% at what debt level value of the firm be optimal?

Transcribed Image Text:

Debt Probability of Bankruptcy $3,000,000 0.10 $6,000,000 0.30 $9,000,000 0.60 Debt Probability of Bankruptcy $3,000,000 0.10 $6,000,000 0.30 $9,000,000 0.60

Answer rating: 100% (QA)

a The optimal level of debt is 3000000 The value of the firm at that level is 1000000... View the full answer