Assume that the tax rate is 40% and bankruptcy costs are negligible until a firm's debt to equity ratio is greater than one.If Madison Co.increases debt from 10% of its capital structure to 40%,cash flows to investors will

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When Madison Co. increases its debt from 10% to 40%, its interest payments will increase. However, since interest payments are tax-deductible, the company's tax bill will decrease. The net effect of this will be an increase in cash flows to investors as the tax savings will exceed the increase in interest payments. This is known as the interest tax shield and is a key benefit of using debt in a firm's capital structure.

Assume That the Tax Rate Is 40% and Bankruptcy Costs