A firm is considering financing a risky project. The project costs $10 million to undertake.

The project will either succeed or fail. If the project succeeds it will be worth $15 million to the firm.

This happens with probability 0.75. If the project fails, the firm can sell it will be worth only $8.5 million.

This happens with probability 0.25. The firm pays corporate taxes of 25%. The tax rate on interest income is 35% and the tax rate on dividend income is 30%.

Assume for simplicity that losses cannot be carried forward or used to offset other taxes of investors.

1. For this part assume that there are no bankruptcy costs. What is the optimal way of financing the firm? Clearly show your workings.

2. Continue to assume that there are no bankruptcy costs. At what tax rate on interest income would the firm be indifferent between using debt and equity to finance itself? Assume that the other tax rates are the same as the previous part.

Use the equity valuation.