When graphing firm value against debt levels,the debt level that maximizes the value of the firm is the level where:
A)the increase in the present value of distress costs from an additional pound of debt is greater than the increase in the present value of the debt tax shield.
B)the increase in the present value of distress costs from an additional pound of debt is equal to the increase in the present value of the debt tax shield.
C)the increase in the present value of distress costs from an additional pound of debt is less than the increase of the present value of the debt tax shield.
D)distress costs as well as debt tax shields are zero.
E)distress costs as well as debt tax shields are maximized.

Question

Quizplus · Accepted Answer

At the point where the increase in the present value of distress costs from an additional pound of debt is equal to the increase in the present value of the debt tax shield, the firm's value is maximized. This point is known as the optimal capital structure. If the firm adds more debt beyond this point, the increase in distress costs will outweigh the benefit of the tax shield, causing the firm value to decrease.

When Graphing Firm Value Against Debt Levels,the Debt Level That