Assume that Gamma’s debt is risk-free up to D/E = 0.25. Then the interest rate increases to 6.5% at D/E = 0.5, 7% at D/E = 0.8, and 8% at D/E = 1.0. As in Problem 21, you can assume that the firm’s overall beta (βA) is not affected by its capital structure or the taxes saved because debt interest is tax-deductible.

CHALLENGE