Omaera an unlevered firm generates average earnings before interest and tax of sh.20m p.a. The market value of the company as at 31^st October 2017, the financial year end was 120m. The management of the company is considering the use of debt finance and have provided the following additional information:

(i)Estimated present value of any future financial distress cost is Shs. 80m.

(ii)The probability of financial distress would rise with leverage according to the following schedule.

Value of debt (sh. M)Probability of financial distress

250.00

500.0125

750.0250

1000.0625

1250.1250

1500.3125

2000.750

(iii)The corporation tax rate is 30%.

Required

(i)Company's optimal level of debt finance using MM model with tax excluding financial distress cost.

(i)Company's optimal level of debt finance using MM with tax model incorporating financial distress cost. (20 marks)