1. **Problem Statement:** A firm plans to raise 2000000 in long-term debt at 11% interest. The current WACC is 12%, and the tax rate is 25%. We need to compute: a) Annual tax shield b) Present value of tax shield (perpetual debt) c) Expected distress cost d) Present value of agency costs (perpetual) e) Net benefit or net loss of adding debt 2. **Formulas and Important Rules:** - Annual tax shield = Interest expense \times Tax rate - Present value of tax shield (perpetual) = Annual tax shield / Cost of debt - Expected distress cost = Increase in probability of distress \times Loss if distress occurs - Present value of agency costs (perpetual) = Annual agency costs / Cost of debt - Net benefit or loss = Present value of tax shield - Expected distress cost - Present value of agency costs 3. **Calculations:** **a) Annual tax shield:** Interest expense = Debt \times Interest rate = 2000000 \times 0.11 = 220000 Annual tax shield = 220000 \times 0.25 = 55000 **b) Present value of tax shield:** Assuming perpetual debt and cost of debt = 11% = 0.11 PV tax shield = 55000 / 0.11 = 500000 **c) Expected distress cost:** Increase in probability = 13% - 5% = 8% = 0.08 Loss if distress occurs = 1800000 Expected distress cost = 0.08 \times 1800000 = 144000 **d) Present value of agency costs:** Annual agency costs = 120000 PV agency costs = 120000 / 0.11 = 1090909.09 **e) Net benefit or net loss:** Net = PV tax shield - Expected distress cost - PV agency costs Net = 500000 - 144000 - 1090909.09 = -734909.09 4. **Interpretation:** The net effect of adding debt is a loss of approximately 734909.09, indicating that the costs outweigh the benefits in this scenario.