Trade off Theory Example Assume an unlevered firm has a value of 100, a tax rate of 25% and would face costs of distress of 15 if it went into bankruptcy. Given the following information, what would be the firm's optimal capital structure? Use: V =V+PV (tax shield) PV (costs of financial distress) So when Debt = 10, Value = 100 + 2.5 - .02*15 = 102.2 Vu 100 100 100 Debt TS 102.5 205 30 7.5 Prob. of default 0.02 0.1 0.3 9944 Costs of Distress 15 15 15 Ex. Cost of Distress 0.3 1.5 4.5 V 102.2 103.5 103 Trade off Theory Example cont'd Continue the previous example but fine tune the amount of debt by considering two more possibilities: Try Debt of 15 assuming a probability of default of .06 And Try Debt of 25 assuming a probability of default of .15 See if either is superior to the Debt level of 20 in the table below: Vu 100 100 100 Ex. Cost of Distress 0.3 Debt 10 20 30 TS 2.5 5 7.5 Prob. of default 0.02 0.1 0.3 Costs of Distress 15 15 Vi 102.2 103.5 103 1.5 15 4.5