Your firm has always purposefully determined its capital structure given the trade-off between the tax benefits and potential bankruptcy costs associated with debt. Currently your firms debt-to-equity ratio is .3. Last year your firm hired a tax wizard. This person is so good at shielding corporate income that your firms corporate marginal tax rate has fallen from .25 to .15. Your firm responds by changing its capital structure to take advantage of this change. Your debt is short-term; so, you will have to refinance anyway.

A. Will you want to increase, decrease, or keep the level of debt the same as it was previously? Explain.

B. Once you do what you suggest (i.e., increase, decrease, or keep the same), what do you predict will happen to the rate your firm must pay on the debt when you refinance? What does the present value of bankruptcy cost have to do with this effect? Explain your answer. (Assume that the yield curve on zero-coupon bonds is essentially that same as it was over the past year.)

C. After your firm alters its capital structure, what happens to its probability of bankruptcy? Explain your answer.