Harry’s Potter's yearly earnings depend on the local weather conditions. If the weather over the year is good (which happens with a probability of .4), Harry’s Potter's pre-tax earnings are high and are equal to $1.4m for the year. If instead local weather turns out to be on average fair (which happens with probability .3), Harry’s Potter's pre-tax earnings are only $1.1m. Finally, if average weather is bad (which happens with probability .3) pre-tax earnings are only $.8m. All of Harry’s Potter's risk is therefore non-systematic. In addition, for tax purposes, Harry’s Potter has depreciation deductions every year of $.4m. The corporate tax rate is τC=35%, the personal tax rate on equity income is τE=14%, and the personal tax rate on interests τP = 28%. The rate on tax-free bonds is r 0=7%. How much debt should Harry’s Potter have in its capital structure?

Using the probabilities. It's based on the debt levels and the tax benefit of debt.