If a company has the optimal amount of debt, then the:
A) direct financial distress costs must equal the present value of the interest tax shield.
B) value of the levered company will exceed the value of the unlevered company.
C) company has no financial distress costs.
D) Value of the firm is equal to VL + TCD.
E) debt-equity ratio is equal to 1.

Question

Quizplus · Accepted Answer

According to the trade-off theory of capital structure, a company can benefit from tax shields of debt and maintain an optimal level of debt where the present value of these tax shields equals the direct financial distress costs. At this optimal level, the value of the levered firm will exceed the value of the unlevered firm due to the tax shield advantage. Therefore, option B is correct. Options A and C are incorrect as an optimal level of debt does not mean zero financial distress costs, and direct financial distress costs are offset by the tax shield benefit. Option D is incorrect as TCD (tax shield benefit) should be subtracted from the value of the levered firm (VL) to arrive at the value of the firm. Option E is incorrect as the optimal debt-equity ratio can vary for different companies and industries, and it does not necessarily need to be equal to 1.

If a Company Has the Optimal Amount of Debt, Then