(ST–1)

MM with Financial Distress Costs B. Gibbs Inc. is an unlevered firm, and it has constant expected operating earnings

(EBIT) of $2 million per year. The firm’s tax rate is 40%, and its market value is V = S = $12 million. Management is considering the use of some debt financing.

(Debt would be issued and used to buy back stock, so the size of the firm would remain constant.) Because interest expense is tax deductible, the value of the firm would tend to increase as debt is added to the capital structure, but there would be an offset in the form of a rising risk of financial distress. The firm’s analysts have estimated, as an approximation, that the present value of any future financial distress costs is $8 million and that the probability of distress would increase with leverage according to the following schedule:

Value of Debt Probability of Financial Distress

$ 2,500,000 0.00%

5,000,000 1.25 7,500,000 2.50 10,000,000 6.25 12,500,000 12.50 15,000,000 31.25 20,000,000 75.00