A firm 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 percent of taxable income. The discount rate for the firms projects is 10 percent.

i. What is the market value of the firm? ii. Now assume the firm issues 50,000 of debt paying interest of 6 percent per year, using the proceeds to retire equity. The debt is expected to be permanent and at present the probability of bankruptcy is negligible. What will happen to the total value of the firm (debt plus equity)? iii. Recompute your answer to (b) under the following assumptions: The debt issue raises the probability of bankruptcy. The firm has a 30 percent 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 percent. Should the firm issue the debt? iv. Discuss the Modigliani and Miller Propositions I and II on optimal capital structure for a firm, including the trade-off theory, with the help of diagrams.