Kansas City Southern, a railroad company, had debt outstanding of $985 million and 40 million shares trading at $46.25 per share in March 1995. It earned $203 million in EBIT, and faced a marginal tax rate of 36.56%. The firm was interested in estimating its optimal leverage using the APV approach. The following table summarizes the estimated bond ratings and probabilities of default at each level of debt from 0% to 90%.

The direct and indirect bankruptcy costs are estimated to be 25% of the firm value. Estimate the optimal debt ratio of the firm, based on levered firm value.

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Debt Ratio (%) Bond Rating Probability of Default (%) 0 10 20 30 40 50 60 70 80 90 0.28 0.28 141 12.20 32.50 46.61 65.00 80.00 80.00 100.00 cCC