According to the trade-off theory, how is the capital structure determined? Firms have an incentive to add leverage to the capital structure. Briefly describe an incentive to add leverage. Then, refer to Equation 16.10 in the material this week and explain how indirect costs of financial distress affect firms in different ways.

Equation 16.10:

Grommit Engineering expects to have net income next year of $20.75 million and free cash flow of $22.15 million. Grommit's marginal corporate tax rate is 35%.

a.) If Grommit increases leverage so that its interest expense rises by $1 million, how will its net income change?

b.) For the same increase in interest expense, how will its free cash flow change?