Quantum Design, Inc. is considering adding debt to their capital structure. Currently, the value of Quantum Designs is $3,000,000 and they are all-equity financed. The CFO would like to issue debt; specifically, $1,000,000 worth of bonds. This debt would mature in ten years. The interest on the bonds would be set at 5%. The CFO estimated that this is the appropriate required rate of return demanded by bondholders of similar debt issues. Quantum Designs pays taxes at a rate of 30%.

a. What is the annual interest tax shield?

b. What is the present value of the interest tax shield?

c. Given your answer in part 2, what is the value of the firm with the debt? (Hint: V_L = V_U + PV_ITS).

d. Considering that most small firms in this industry experience direct and indirect costs of financial distress at about 20% of firm value (firm value when the firm is all equity financed, i.e., $3,000,000 in this case), what would be your recommendation to the CFO of Quantum Designs regarding the proposed change to their capital structure?