X-Tex Industries has large depreciation tax deductions and can thus eliminate all of its taxable income with a relatively small amount of debt. In contrast, Unique Scientific Equipment Corporation is generating a substantial amount of taxable income. Despite the tax advantage of debt, Unique uses only a modest amount of debt financing because the nature of its products would make financial distress very costly. Suppose the rate of inflation increased from 3 percent to 6 percent, increasing borrowing rates from 6 percent to 9 percent. How would this affect the optimal capital structures of these two firms?

AppendixLO1