Question

1. 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.	30%
   	B.	50%
   	C.	20%
   	D.	40%

Answer 1

Ans : Will compute PV of Net Cash Flows at each level of Debt

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)
PV of Net Cash Flows	0.5	1.75	1.50	1.4	(1)

Ans :The Optimal Capital (debt level) of the firm is closest to 20% since PV of net cash flows is highest at 20% debt level i.e. the net benefit from Interest tax shield and after subject to finace distress cost is highest at 20% level.