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 (b_assets) 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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