Klearcut Forestry Inc generates perpetual annual EBIT of $100 million.

Klearcut Forestry Inc generates perpetual annual EBIT of $100 million. Assume that the EBIT, and all other cash flows, occur at year end and that we are currently at the beginning of a year.

Assume that all of the perfect market M&M assumptions hold and that the corporate tax rate is 35%. The CFO of Klearcut is trying to determine the company’s optimal capital structure. Which of the debt-to-equity ratios listed below will maximize Klearcut’s value?
A) D/E = 0.5
B) D/E = 1.0
C) D/E = 1.5
D) D/E = 2.0
E) D/E = 2.5

ANSWER

E