Mechano Construction Inc.generates perpetual annual EBIT of $500.The corporate tax rate is 35%.Mechano has 300 shares outstanding that trade for $6.89.Mechano has debt worth $1,512 and its debt-to-equity ratio is 0.667.The CFO of Mechano is thinking about borrowing another $100 to repurchase shares.However,the additional debt will increase the present value of financial distress costs by $40.The CFO wants to maximize the value of the firm.What is the benefit of the additional debt minus the cost of the additional debt?

Question

Quizplus · Accepted Answer

The benefit of the debt is the marginal increase in firm value. That is given by T × D or 0.35 × $100 = $35. The cost of the increased leverage is the increase in the present value of distress costs or $0. The benefit minus the cost is $35 - $40 = -$5.