7. Acme-Menderhall Corporation is trying to determine an appropriate capital structure. It knows that as its leverage increases, its cost of borrowing will eventually increase, as will the required rate of return on its common stock.

The company has made the following estimates for various leverage ratios:

Required Rate of Return on Equity WITHOUT WITH Interest Rate BANKRUPTCY AND BANKRUPTCY AND Debt/(Debt + Equity) on Borrowings AGENCY COSTS AGENCY COSTS 0 - 1o0/o 10%

.10 8% 14 1%

.20 8 11 lli

.30 % 11% 12

.40 9 12i 13

.50 10 14 1%

.60 11 1% 1%

.70 125 16 1%

.80 15 18 21