Compare and Contrast the alternative methods for determining the Optimal Capital Structure described here. The Best Circuit Company currently has no profitable growth opportunities or debt. An in-house research group has just been assigned the job of determining whether the firm should change its capital structure. Because of the importance of the decision, management has also hired the investment banking firm of Stanley Morgan & Company to conductaparallelanalysisofthesituation. Mr.Harris,thein-houseanalyst,whoiswellversedin modern finance theory, has decided to carry out the analysis using the MM framework. Ms. Broske, the Stanley Morgan consultant, who has a good knowledge of capital market conditions and is confident of her ability to predict the firms debt and equity costs at various levels of debt, has decided to estimate the optimal capital structure as that structure which minimizes the firms weighted average cost of capital. The following data are relevant to both analyses:

EBIT Federal-plus-state tax rate Dividend payout ratio Current required rate of return on equity

The cost of capital schedule predicted by Ms. Broske follows:

At a Debt Level of (Millions of Dollars)

$0 $2

Interest rate (%) - 8.0 Cost of equity (%) 12.0 12.5

$4 $6 $8

8.3 9.0 10.0 13.25 13.75 14.5

$10 $12 $14

11.0 13.0 16.0 15.75 17.25 19.0

Mr.Harrisestimatedthepresentvalueoffinancialdistresscostsat$20million. Additionally, he estimated the following probabilities of financial distress:

Probability of financial distress (Note: doesn't add to 1.00)

At a Debt Level of (Millions of Dollars) $0 $2 $4 $6 $8 $10 $12 $14

0 0 0.05 0.07 0.10 0.17 0.47 0.90

= $4 million per year, in perpetuity. = 40%. = 100%. = 12%.

a. What level(s) of debt would Mr. Harris and Ms. Broske each recommend as optimal?

b. Explain the similarities and differences in their approaches not in their solutions. Is one approachrightandtheotherthereforewrong? Explaininoneparagraphof75wordsorless.