Problem #5 (16 marks)

Pecora is an all equity company with EBIT of $850,000 per year which will continue

forever as the company pays out all earnings in the form of dividends (i.e. no growth).

You must determine the optimal capital structure for this company. You have been

provided with the following additional information: T-bills are currently yielding 3%; the

market risk premium is 7%; the company's tax rate is 35%; and costs of financial distress

apply. Assume the market value of debt is equal to its book value.

Value of Debt Cost of Debt (Rd) Beta PV of Financial Distress Costs SO 1 $1,000,000 4% $200,000 $2,000,000 5% 1.35