Optimal leverage with a variable borrowing rate

Abstract

This article is a theoretical examination of optimal leverage to maximize the value of an investment asset, assuming that the interest rate on loans increases with leverage. The expected rate of return to equity for the investing firm (that is subject to taxation at the entity level) and market equilibrium for the model are derived. The amount of risk that is assumed by investing firms that borrow is set by the competitive market. The article also includes a model of the capitalization rate for commercial real estate, defined as net operating income divided by property value (which depends upon leverage).

Keywords:

• leverage
• variable borrowing rate
• Modigliani–Miller theorem
• capitalization rate

JEL Classification:

• G00
• G12