Suppose LD Bank is funded with 2% equity and 98% debt. Its current market capitalization is $10 billion, and its market to book ratio is 1. LD Bank earns a 4.22% expected return on its assets (the loans it makes), and pays 4% on its debt. New capital requirements will necessitate that LD Bank increase its equity to 4% of its capital structure. It will issue new equity and use the funds to retire existing debt. The interest rate on its debt is expected to remain at 4%.

a. What is LD Banks expected ROE with 2% equity?

b. Assuming perfect capital markets, what will LD Banks expected ROE be after it increases its equity to 4%?

c. Consider the difference between LD Banks ROE and its cost of debt. How does this premium compare before and after the Banks increase in leverage?

d. Does the reduction in Levered Banks ROE after the increase in equity reduce its attractiveness to shareholders? Explain.