Your firm has zero$-$coupon debt with a face value of $$100$ million due in $5$ years$$ time, and no other debt outstanding. The current risk$-$free rate is $5\%,$ but due to default risk the yield$-$to$-$maturity of the debt is $12\%($ytm$).$

You believe that in the event of default, $10\%$ is attributable to bankruptcy and Financial distress costs. $($For example, if the debt holders lose $$60$ million and recover $$40$ million, $$6$ million of the loss in value would not have occurred if the firm had been unlevered and thus avoided bankruptcy.$)$

We are going to estimate the Present Value of the Financial distress costs in a few steps:

$1\mathrm{.}4)$

Financial distress begins when debt levels rise $($too high$).$ In Finance we use different ratios to measure this. Name at least one ratio and add its target leve