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A public company with no debt is contemplating issuing its first corporate bonds. The company generates quite a bit of revenue and could benefit from
A public company with no debt is contemplating issuing its first corporate bonds. The company generates quite a bit of revenue and could benefit from expensing interest debt to shield some of its revenue from taxes. It estimates that the value of the tax shields created by the debt issuance would be proportional to the ratio of debt to assets, x, and would be given by the following formula: D(x) = 0.2.x However, the company also knows that debt comes with certain unique costs, such as lost opportunities due to maxed out debt capacity. It estimates that these costs are generally small for small amounts of debt, but increase fast as the amount of debt increases. It believes that the following quadratic function would capture fairly well these costs: V(x) 0.2x? + 0.1 x The company also knows that the ratio of debt to assets cannot be larger than 1 or smaller than 0. We now want to determine the optimal amount of debt that the company should issue. Q1: Express the net benefit to the firm (benefit minus cost) of issuing debt as a function of x. Net benefit equals Q2: Find the debt-to-assets ratio x that maximizes the firm's net benefit function. The optimal debt-to-asset ratio is x =
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