Ground Hog Day, Inc., an unlevered firm, has one million shares of stock outstanding at a price of $18 per share. (The firms tax rate is 25%.). The stock has a beta of 1, and the risk-free rate is 8%. (Assume that market risk premium = 6%.). Management is considering the use of debt ranging from $2.5 to $8.0 million; debt would be issued and used to buy back stock, and the size of the firm would remain constant. The firms analysts have estimated:

1) that the present value of agency cost associated with new debt is 10% of the debt amount used

2) that the present value of any bankruptcy cost is $10 million and that the probability of bankruptcy will increase with leverage according to the following schedule:

Value of debt

in millions

Probability

of default %

2.5 0

5 10

7.5 20

8 22

What is the value of the firm (in millions) for option 1?

Answer for part 1

What is the value of the firm (in millions)for option 2?

Answer for part 2

What is the value of the firm (in millions)for option 3?

Answer for part 3

What is the value of the firm (in millions)for option 4?

Answer for part 4

Which option is the optimal debt level? (1, 2, 3 or 4)

Answer for part 5

Calculate the debt ratio for the optimal capital structure

Answer for part 6

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