Chuma Company Ltd is considering various levels of debt. Currently it has no debt. It has a total market value of Sh.30 million. By undertaking debt...

      

Chuma Company Ltd is considering various levels of debt. Currently it has no debt. It has a total
market value of Sh.30 million. By undertaking debt it believes that it can achieve a net tax advantage
equal to 20% of the amount of debt. However the company will incur bankruptcy and agency costs
as well as lenders increasing their interest rate if it borrows too much. The company‟s
managing director believes that the company can borrow up to Sh.10 million without incurring
any of these costs. However, each additional Sh.10 million increment in borrowing is expected to
result in the three costs cited being incurred. Moreover, the three costs are expected to increase at
an increasing rate with leverage. The present value cost of various levels of debt is as follows:

Required:
Advise the managing director on the optimal amount of debt for Chuma Company.

  

Answers

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Kavungya answered the question on April 16, 2021 at 12:53

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