You are a CFO of a firm with $2.5 million of excess cash. You decide to use this cash either to repurchase equity or to retire all of the outstanding debt. All of the debt is holding by a financial institution who is willing to sell it back to your firm for $2.5 million. The firm will remain to be an unlevered forever if the firm becomes an all-equity firm. However, if your firm does not retire the debt, it will use the $2.5 million in cash to buy back some of the stocks on the open market. Assume that there is no transaction costs for stock repurchases and debt transactions.

Your firm will be able to have $1.3 million of annual earnings (EBIT) in perpetuity regardless of the capital structure. The firm immediately pays out all earnings in the form of dividends at the end of each year.

Assume that the firm is subject to a corporate tax rate of 21% and the required rate of return on the firms unlevered equity is 20%. The personal tax rate on interest income is 25% and there are no taxes on equity distributions. We also assume that the bankruptcy cost is zero.

Assume that the expected bankruptcy costs have a present value of $500,000. How does this influence your decision about whether you will choose to repurchase stock or retire debt?