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XYZ is a no-growth firm and its current unlevered value is VU=$800,000, and its marginal corporate...

XYZ is a no-growth firm and its current unlevered value is VU=$800,000, and its marginal corporate tax rate is 35%. Also, you model the Firm's PV of financial distress as a function of its debt ratio (D/VU) according to the relation:PV of financial distress=800,000 x (D/V)^2. The optimal percentage of perpetual debt (D) to the levered firm value (i.e. D/VL, the effective debt/value-ratio), given debt proceeds are used to buy back stock, is closest to: a) 0.25 b) 0.6 c) 0.76 d) 0.17.

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Answer #1

the rate of DV Ratio at which Value of levered firm is highest is the optimal percentage (Option D 0.17 is the answer)

a. 0.25

Value of levered firm = Value of unlevered firm + Debt*tax - PV(financial distress)

Value of levered firm = 800000 + 200000*0.35 -800000 * 0.25^2

Value of levered firm = $820000

b. 0.60

Value of levered firm = Value of unlevered firm + Debt*tax -PV(financial distress)

Value of levered firm = 800000 + 480000*0.35 -800000 * 0.60^2

Value of levered firm = $680000

c. 0.76

Value of levered firm = Value of unlevered firm + Debt*tax -PV(financial distress)

Value of levered firm = 800000 + 608000*0.35 -800000 * 0.76^2

Value of levered firm = $550720

d. 0.17

Value of levered firm = Value of unlevered firm + Debt*tax -PV(financial distress)

Value of levered firm = 800000 + 136000*0.35 -800000 * 0.17^2

Value of levered firm = $824480

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