What would happen to a firm that uses an excessive amount of debt in a world with no taxes?
A)The value of the firm would increase because of the increase in the assets of the firm.
B)The value of the firm would decrease because of the increase in the present value of distress costs.
C)It is completely irrelevant to the size of the firm.
D)The value of distress costs do not affect a firm in a tax-free world.

Question

Quizplus · Accepted Answer

In a world with no taxes, the interest paid on debt is not tax-deductible, thus making the use of debt less attractive. Using excessive debt increases the present value of distress costs because the probability of bankruptcy would increase. This would, in turn, decrease the value of the firm. Therefore, option B is the correct answer.

What Would Happen to a Firm That Uses an Excessive