If the present value of the interest tax shield on debt equals the present value of the costs of financial distress,then the trade-off theory implies that the:
A) firm is using the optimal level of debt.
B) firm is paying too high an interest rate.
C) firm's market value equals its book value.
D) firm should increase its use of debt.

Question

Quizplus · Accepted Answer

The trade-off theory suggests that a firm should use debt up to the point where the present value of the interest tax shield is equal to the present value of the costs of financial distress. If the present value of these two factors is equal, then the firm is using the optimal level of debt, and therefore, Answer A is correct. Answer B is incorrect because there is no information to suggest that the firm is paying too high an interest rate. Answer C is also incorrect because the relationship between the firm's market value and book value is not relevant to the trade-off theory. Finally, Answer D is incorrect because the firm is already using the optimal level of debt, and increasing the use of debt could cause the costs of financial distress to outweigh the benefits of the interest tax shield.

If the Present Value of the Interest Tax Shield on Debt