You are the CFO of Livwell, an unlevered firm with constant EBIT of $4,000,000 per year in perpetuity. You are considering the use of some debt financing to repurchase shares. You have developed the following schedule based on the PV of bankruptcy costs of $10,000,000:

Value of Debt

$1,000,000 1,500,000 2,500,000 5,000,000 10,000,000 15,000,000 18,000,000

Probability of financial distress

0.00% 1.50% 3.00% 6.50% 15.50% 40.00% 65.00%

Cost of Debt

1% 3% 4% 5% 6% 12% 15%

The current cost of equity is 12%, and the tax rate is 40%.

a) What is Livwells market value and the WACC before any debt is taken on? (3 marks)

b) According to M&Ms case (world) II, what is Livwells optimal level of debt? No calculation required (2 marks)

c) What is the optimal capital structure when financial distress costs are included? (16 marks)

d) Compute the WACC at the optimal capital structure determined in part (c). (7 marks)