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Progressive Home Health Care Inc. is a for-profit provider of home health care services in the Pacific Northwest. At present, it has EBIT of $2
Progressive Home Health Care Inc. is a for-profit provider of home health care services in the Pacific | |||||||
Northwest. At present, it has EBIT of $2 million per year, no debt, and a market value of approximately | |||||||
$12 million. Although management is pleased with the good financial condition of Progressive, they are | |||||||
also concerned that the firm might be the target of a potential hostile takeover by a large competitor. | |||||||
Therefore, Progressive is considering issuing debt to buy back shares, the interest on which would be tax | |||||||
deductible (its tax rate is 40 percent). Management recognizes that as the amount of debt increases, both | |||||||
the value of the firm and the risk of financial distress increase. The CFO estimates that the present value | |||||||
of any future financial distress costs is $8 million, and that the probability of distress increases with the | |||||||
amount of debt in the following steps: | |||||||
Probability | |||||||
of financial | |||||||
Value of debt | distress | ||||||
0 | 0% | $12,000,000.0 | |||||
$2,500,000 | 1% | $13,000,000.0 | |||||
$5,000,000 | 2% | $14,000,000.0 | |||||
$7,500,000 | 4% | $15,000,000.0 | |||||
$10,000,000 | 8% | $16,000,000.0 | |||||
$12,500,000 | 16% | $17,000,000.0 | |||||
$15,000,000 | 32% | $18,000,000.0 | |||||
$20,000,000 | 64% | $20,000,000.0 | |||||
a. What is Progressive's cost of equity and corporate cost of capital now? | |||||||
b. According to MM with corporate taxes, what is the optimal level of debt? | |||||||
c. According to MM with corporate taxes and financial distress, what is the optimal level of debt? | |||||||
d. Plot the value of Progressive, with and without the costs of financial distress, as a function of the amount | |||||||
of debt. Why do the lines differ in shape? |
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