Question

ACCM Inc. is considering adding leverage to its capital structure. The firm’s managers believe they can issue more debt to exploit the tax benefit of leverage. However, they also recognize that higher debt increases the risk of financial distress. Based on simulation of the firm’s future cash flows, the managers have made the following estimates (in millions of dollars) for different levels of debt (%) in the firm capital structure.

Debt level	10%	20%	30%	40%	50%
PV(Interest tax shield)	1	2.5	3.75	4.5	5.25
PV(Financial distress cost)	0.5	0.75	2.25	3.1	6.25

The optimal capital structure (debt level) of the firm is closest to:

	A.	50%
	B.	40%
	C.	30%
	D.	20%

Answer 1

PV of net cash flow at 10% = PV of interest tax shield - PV of distress cost = 1 - 0.50 = $0.50 M

PV of net cash flow at 20% = PV of interest tax shield - PV of distress cost = 2.50 - 0.75 = $1.75 M

PV of net cash flow at 30% = PV of interest tax shield - PV of distress cost = 3.75 - 2.25 = $1.50 M

PV of net cash flow at 40% = PV of interest tax shield - PV of distress cost = 4.50 - 3.10 = $1.40 M

PV of net cash flow at 40% = PV of interest tax shield - PV of distress cost = 5.25 - 6.25 = - $1.00 M

The PV of net cash flow is highest at 20% thus Optiomal capital structure lies at 20%

Option D 20%