hard · Principles of Finance

If the tax rate increases, how should the firm theoretically adjust its capital structure to remain at the new optimum, assuming no other changes?

1. Maintain the current ratio because the optimal point is determined only by business risk.
2. Decrease the Debt-to-Equity ratio because the firm's after-tax cash flows have declined.
3. Increase the Debt-to-Equity ratio to capture the now-more-valuable interest tax shields.
4. Switch entirely to equity to maximize the remaining net income available to shareholders.

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