benefitsandaddingbacktheexpectedbankruptcycostfrom
the existing debt.
The only components that change as a firm changes its
leverage are the expected tax benefits and the expected
bankruptcy costs. To obtain these values as we change
leverage, we would go through the following steps.
1.Estimatethedollardebtoutstandingateachdebtratio.This
processmirrorswhatwasdoneinthecostofcapitalapproach.
Keepingfirmvaluefixed,weconsiderhowmuchdebtthe
firm will have at 20 percent debt, 30 percent debt, and so on.
2.Estimatethetaxbenefitsofdebtbymultiplyingthedollar
debtbythetaxrate.Thisessentiallyassumesthatthedebtis
permanent and that the tax benefits will continue in
perpetuity.
3.Estimatetherating,interest rate,and interestexpenseat
eachdebtratio.Thisprocessagainreplicateswhatwasdone
in the cost of capital approach.
4.Usetheratingtoestimateaprobabilityofdefault.Notethat
Table 6.2provides these probabilities for each rating.
5.Estimatetheexpectedbankruptcycostbymultiplyingthe
probabilityofbankruptcybythecostofbankruptcy,statedas
a percent of firm value.