Stinton Vintage Wine Company is currently family owned and has no debt. The Stinton family is considering going public by selling some of their stock in the company. Investment bankers tell them the total market value of the company is $10 million if no debt is employed. In addition to selling stock, the family wishes to consider issuing debt that, for computational purposes, would be perpetual. The debt would then be used to purchase and retire common stock, so that the size of the company would stay the same. Based on various valuation studies, the present value of the tax-shield benefits is estimated at 22 percent of the amount borrowed when both corporate and personal taxes are taken into account. The company's investment banker has estimated the following present values for bankruptcy costs associated with various levels of debt:
DEBTPRESENT VALUE OF BANKRUPTCY COSTS
$1,000,000…………………………. $ 0
2,000,000…………………………... 50,000
3,000,000…………………………... 100,000
4,000,000…………………………... 200,000
5,000,000…………………………... 400,000
6,000,000…………………………... 700,000
7,000,000…………………………...1,100,000
8,000,000…………………………...1,600,000
Given this information, what amount of debt should the family choose?