30. Trade-Off Theory. Smoke and Mirrors currently has EBIT of $25,000 and is all-equity- financed. EBIT is

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30. Trade-Off Theory. Smoke and Mirrors currently has EBIT of $25,000 and is all-equity- financed. EBIT is expected to stay at this level indefinitely. The firm pays corporate taxes equal to 35% of taxable income. The discount rate for the firm's projects is 10%. (LO3)

a. What is the market value of the firm?

b. Now assume the firm issues $50,000 of debt paying interest of 6% per year, using the pro- ceeds to retire equity. The debt is expected to be permanent. What will happen to the total value of the firm (debt plus equity)?

c. Recompute your answer to

(b) under the following assumptions: The debt issue raises the probability of bankruptcy. The firm has a 30% chance of going bankrupt after 3 years. If it does go bankrupt, it will incur bankruptcy costs of $200,000. The discount rate is 10%. Should the firm issue the debt?

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