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?

Debt Principal in $ millions ro Probability of Financial Distress Estimates under Different Debt Levels 0 0 0.0% 40 3.50% 0.0% 60 4% 1.0% 80 4.50% 5.0% 90 5% 0.0% Debt Principal in $ millions ro Probability of Financial Distress Estimates under Different Debt Levels 0 0 0.0% 40 3.50% 0.0% 60 4% 1.0% 80 4.50% 5.0% 90 5% 0.0%