According to the managerial entrenchment theory, managers choose capital structure so as to preserve their
control of the firm. On the one hand, debt is costly for managers because they risk losing control in the event of default. On the other hand, if they do not take advantage of the tax shield provided by debt, they risk losing control through a hostile takeover. Suppose a firm expects to generate free cash flows of $ 87 million per year, and the discount rate for these cash flows is 12 %. The firm pays a tax rate of 35 %. A raider is poised to take over the firm and finance it with $ 620 million in permanent debt. The raider will generate the same free cash flows, and the takeover attempt will be successful if the raider can offer a premium of 26 % over the current value of the firm. According to the managerial entrenchment hypothesis, what level of permanent debt will the firm choose?
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