As a firm takes on more debt, its probability of bankruptcy increases or decreases . Other factors held constant, a firm whose earnings are relatively volatile faces a greater or lesser chance of bankruptcy. Therefore, when other factors are held constant, a firm whose earnings are relatively volatile should use less or more debt than a more stable firm. When bankruptcy costs become more important, they reduce or increase the tax benefits of debt.

General Forge and Foundry Corporation currently has no debt in its capital structure, but it is considering using some debt and reducing its outstanding equity. The firms unlevered beta is 1.25, and its cost of equity is 13.00%. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 13.00%. The risk-free rate of interest (rRFrRF) is 3%, and the market risk premium (RPMRPM) is 8%. General Forges marginal tax rate is 25%.

General Forge is examining how different levels of debt will affect its costs of debt and equity, as well as its WACC. The firm has collected the financial information that follows to analyze its weighted average cost of capital (WACC). Complete the following table.

D/Cap RatioE/Cap RatioD/E RatioBond RatingBefore-Tax Cost of Debt (rdrd)Levered Beta (b)Cost of Equity (rsrs)WACC0.01.00.001.2513.00%13.00%0.20.80.25A8.4% 14.872%13.158%0.40.60.67BBB8.9%1.87518.000% 0.60.41.50BB11.1%2.656 14.694%0.80.2 C14.3%5.00043.000%