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considering the use of debt; debt would be issued and used to buy back stock, and the size of
the firm would remain constant. The default free interest rate on debt is 12%. Since interest
expense is tax deductible, the value of the firm would tend to increase as debt is added to the
capital structure, but there would be an offset in the form of the rising cost of bankruptcy.
The firm's analysts have estimated, approximately, that the present value of any bankruptcy
cost is $8 million and the probability of bankruptcy will increase with leverage according to
the following schedule:
Value of debt Probability of failure
$ 2,500,000 0.00%
$ 5,000,000 8.00%
$ 7,500,000 20.5%
$ 8,000,000 30.0%
$ 9,000,000 45.0%
$10,000,000 52.5%
$12,500,000 70.0%
a. What is the cost of equity and WACC at this time?
b. What is the optimal capital structure when bankruptcy costs are considered?
c. What will the value of the firm be at this optimal capital structure?

24. A firm that has no debt has a market value of $100 million and a cost of equity of
11%. In the Miller-Modigliani world,
a. What happens to the value of the firm as the leverage is changed? (Assume no taxes)
b. What happens to the cost of capital as the leverage is changed? (Assume no taxes)
c. How would your answers to (a) and (b) change if there are taxes?

25. Assume that personal investors pay a 40% tax rate on interest income and only a 20%
tax rate on equity income. If the corporate tax rate is 30%, estimate whether debt has
a tax benefit, relative to equity. If a firm with no debt and $ 100 million in market
value borrows money in this world, estimate what the value of the firm will be if the
firm borrows $ 50 million.


26. In the illustration above, what would the tax rate on equity income need to be for debt
to not have an effect on value?

27. XYZ Pharma Inc. is a pharmaceutical company that traditionally has not used debt to
finance its projects. Over the last 10 years, it has also reported high returns on its
projects and growth, and made substantial research and development expenses over
the time period. The health care business overall is growing much slower now, and
the projects that the firm is considering have lower expected returns.
a. How would you justify the firm™s past policy of not using debt?
b. Do you think the policy should be changed now? Why or why not?

28. Unitrode Inc., which makes analog/linear integrated circuits for power management,
is a firm that has not used debt in the financing of its projects. The managers of the
firm contend that they do not borrow money because they want to maintain financial
a. How does not borrowing money increase financial flexibility?
b. What is the trade-off you would be making, if you have excess debt capacity, and
you choose not to use it, because you want financial flexibility?

29. Consolidated Power is a regulated electric utility which has equity with a market
value of $ 1.5 billion and debt outstanding of $ 3 billion. A consultant notes that this
is a high debt ratio relative to the average across all firms, which is 27%, and suggests
that the firm is overlevered.
a. Why would you expect a electric utility to be able to maintain a higher debt ratio
than the average company?
b. Does the fact that the company is a regulated monopoly affect its capacity to carry



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