When firms issue more debt, the tax shield on debt ____, the agency costs on debt (i.e., costs of financial distress) ____, and the agency costs on equity ____.
A) increases; increases; increases
B) decreases; decreases; decreases
C) increases; increases; decreases
D) decreases; decreases; increases
E) increases; decreases; decreases

Question

Quizplus · Accepted Answer

When firms issue more debt, the tax shield on debt increases because interest payments on debt are tax-deductible, reducing the firm's taxable income. The agency costs on debt increase due to the higher risk of financial distress associated with increased debt levels. The agency costs on equity decrease because debt holders have a priority claim over equity holders, which can reduce the equity holders' incentive to undertake risky projects that might not be in the best interest of the debt holders.

When Firms Issue More Debt, the Tax Shield on Debt