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Kappa AB plans to change its capital structure and increase its leverage. The actual debt/equity ratio is 1/2. Apart from the current ratio , the

Kappa AB plans to change its capital structure and increase its leverage. The actual debt/equity ratio is 1/2. Apart from the current ratio , the firm considers two more options, either 4/3 or 5/3. The risk-free interest rate is 5% and the market risk premium is 6%. The beta-value of its assets (bassets) is 1. The companys tax rate is 28%. Kappa can borrow at the following interest rates, which differ, depending on the debt/equity ratio:

Debt/Equity ratio

Interest rate (rD)

1/2

5%

4/3

6%

5/3

8%

(i) (1 point) Can you explain why should it pay higher rates for higher debt/equity ratios?

(ii) (4 points) Which of these three leverage ratios is optimal? Why?

(iii) (1 point) Would your decision in (ii) above change if its higher debt/Equity ratio was financed at 5% interest rate?

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