Solved: Progressive Home Health Care Inc is a for profit

provider of

Progressive Home Health Care Inc. is a for-profit provider of home health care services in the
Pacific Northwest. At present, it has EBIT of $2 million per year, no debt, and a market value of
approximately $12 million. Although management is pleased with the good financial condition of
Progressive, they are also concerned that the firm might be the target of a potential hostile
takeover by a large competitor. Therefore, Progressive is considering issuing debt to buy back
shares, the interest on which would be tax deductible (its tax rate is 40 percent). Management
recognizes that as the amount of debt increases, both the value of the firm and the risk of
financial distress increase. The CFO estimates that the present value of any future financial
distress costs is $8 million, and that the probability of distress increases with the amount of debt
in the following steps:
Probability of financial Value of debt distress
0 ................ 0%
$2,500,000 ............ 1%
$5,000,000 ............ 2%
$7,500,000 ............ 4%
$10,000,000 ........... 8%
$12,500,000 ........... 16%
$15,000,000 ........... 32%
$20,000,000 ........... 64%
a. What is Progressive's cost of equity and corporate cost of capital now?
b. According to MM with corporate taxes, what is the optimal level of debt?
c. According to MM with corporate taxes and financial distress, what is the optimal level of debt?
d. Plot the value of Progressive, with and without the costs of financial distress, as a function of
the amount of debt. Why do the lines differ in shape?

Progressive Home Health Care Inc is a for profit provider of

ANSWER
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