1)

Edinburgh Plc. is an all-equity funded firm that is considering borrowing 1 million at a market interest rate of 6%. The loan requires payments of annual interest for the next 10 years and repayment of the the principal at the end of year 10. The company faces a 20% marginal tax rate. What is the value of the tax benefits that Edinburgh Plc. will get just from the ten-year loan?

Now consider this situation:

Sunny Corp. is considering adding leverage to its capital structure. The company's managers believe that they can add as much as $35 million in debt and exploit the benefits of tax shield with an estimated tax rate of 15%. However, they also recognize that higher debt increases the risk of financial distress. Based on simulations of the firm's future cash flows, the CFO made estimates as below. What is the optional debt choice for Sunny Corp. based on these estimates? Debt ($ million) 0 10 20 25 30 35 0 1.5 3 3.75 4.5 5.25 PV of interest tax shield ($ mil) PV of financial distress cost ($ mil) 0 0 0.38 1.62 4 6.38