OPTIMAL DEBT AND EQUITY MIX

The firm's performance for the previous year is:

Sales: $10,000,000

Variable cost: 3,000,000

Fixed cost: 3,000,000

Net operatig income: 4,000,000

Firm needs 10,000,000 of new external capital. Expected to increse net operatig income by 7% per year.

Equity beta was 1.25. the risk free rate was 6%, and the expected market return was 12%. No long term debt outstanding.

With debt, the probability of default will be:

Debt: 1,000,000/ Rate: 9.00%/ Prob of default: 4%

Debt: 2,000,000/ Rate: 9.80%/ Prob of default: 12%

Debt: 3,000,000/ Rate: 10.70%/ Prob of default: 22%

Debt: 4,000,000/ Rate: 12.20%/ Prob of default: 34%

Debt: 5,000,000/ Rate: 15.50%/ Prob of default: 50%

It is estimated that the cost of the loan default would be 3,000,000.

38% tax bracket.

What should be the optimal debt and equity mix for the 10,000,000?