Question 4 - Optimal Leverage under Trade-off Theory

Your firm currently has no debt and a marginal tax rate of 40%. You are contemplating issuing a one-year bond to pay your shareholders a one-time dividend, but you are unsure how much debt to issue. After one year you will repay the debt. However, depending on how much debt you issue you will face a different interest rate and a different probability of financial distress (see table below). If you experience financial distress you expect the present value of distress costs to be $10 million. Assume that there are no agency benefits and no agency costs associated with this transaction. How much debt should you issue?

Estimates under Different Debt Levels

Debt Principal in $ millions 0 40 60 80 90

rD 0 3.50% 4% 4.50% 5%