OPTIMAL DEBT AND EQUITY MIX
The firm's performance for the previous year is:
Sales: $10,000,000
Variable cost: 3,000,000
Fixed cost: 3,000,000
Net operatig income: 4,000,000
Firm needs 10,000,000 of new external capital. Expected to increse net operatig income by 7% per year.
Equity beta was 1.25. the risk free rate was 6%, and the expected market return was 12%. No long term debt outstanding.
With debt, the probability of default will be:
Debt: 1,000,000/ Rate: 9.00%/ Prob of default: 4%
Debt: 2,000,000/ Rate: 9.80%/ Prob of default: 12%
Debt: 3,000,000/ Rate: 10.70%/ Prob of default: 22%
Debt: 4,000,000/ Rate: 12.20%/ Prob of default: 34%
Debt: 5,000,000/ Rate: 15.50%/ Prob of default: 50%
It is estimated that the cost of the loan default would be 3,000,000.
38% tax bracket.
What should be the optimal debt and equity mix for the 10,000,000?