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d'Anconia Copper is considering issuing one-year debt,and has come up with the following estimates of the value of the interest tax shield and the probability of distress for different levels of debt:
-If in the event of distress,the present value of distress costs is equal to $10 million,then the optimal level of debt for d'Anconia Copper is:

Question

Use the following information to answer the question(s)below.
d'Anconia Copper is considering issuing one-year debt,and has come up with the following estimates of the value of the interest tax shield and the probability of distress for different levels of debt: 
-If in the event of distress,the present value of distress costs is equal to $10 million,then the optimal level of debt for d'Anconia Copper is:

Quizplus · Accepted Answer

The optimal level of debt is the one that maximizes the value of the company. The value of the company can be calculated as the sum of the value of the interest tax shield and the probability-weighted present value of avoiding distress costs. The value of the interest tax shield increases with the level of debt, while the probability of distress and the present value of distress costs increase with the level of debt as well. Therefore, there is an optimal level of debt where the marginal benefit of the interest tax shield is equal to the marginal cost of the probability of distress and the present value of distress costs. From the table, this occurs at a debt level of $60 million, where the value of the interest tax shield is $7.2 million, and the probability-weighted present value of avoiding distress costs is $4.8 million. Any higher level of debt would increase the probability of distress and the present value of distress costs more than it would increase the value of the interest tax shield, resulting in a decrease in the overall value of the company.

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