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:

Debt Level (in $ million)

0 40 50 60 70 80 90 PV (interest tax shield, in $ million) 0.00 0.76 0.95 1.14 1.33 1.52 1.71 Probability of Financial Distress 0% 0% 1% 2% 7% 16% 31%

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. $2 million?

b. $5 million?

c. $25 million?

AppendixLO1