Omega Co would like to analyze its capital structure and assess whether it should add more debt to its capital. The current market value of debt of the firm is $800 million and the current market value of equity is $1,900 million. The firm has an EBIT of $140 million and faces a tax rate of 32%. The companys bonds are rated AA and the cost of debt is 5%. Currently, the firm has a probability of default of 2.5% and a bankruptcy cost which is 20% of the current value of the firm.

a. Estimate the unlevered value of the firm [ 4 marks]

b. Estimate the levered value of the firm, at a debt ratio of 40% of the current firm value. At that debt ratio, the firms bond rating will be BBB, and the probability of default will increase to 38% while the bankruptcy cost will remain at 20% of the current firm value. [3 marks]

c. Should the firm change its debt ratio to 40%? Why or why not? In a few words, describe a capital restructuring strategy that the firm can use to achieve this new debt ratio. [3 marks]