In line with the corporate …show more content…
Detailed calculations can be found in Exhibit 1 for D/V ratios (book basis) from 10% to 100%. Although we used book D/V as the label for each option (consistent with the case text), our debt rating/risk of default calculations were done using market D/V as described above. Using a tax rate of 48% tax rate and an assumption that the price will remain at $30, for different debt to value ratios, we can see that the present value of the tax shield increases as we increase debt, with interest rates also slowing increasing and the WACC slowly decreasing.
The tax shield benefit must be compared to the costs of financial distress. Cost of financial distress was calculated using the formula: Exp. cost of FD=prob. of FD × cost of FD of default where FD is financial distress. We also assumed the interest rate charged would increase as debt rose to reflect the increased risk. With the yield premium on AAA and BBB debt as endpoints, we used linear interpolation to estimate the yield premium at the intermediate bond ratings. We also used bond ratings to estimate the probability of default using historical data. Our calculations yielded the following:
The costs of financial distress are