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. However, the agency costs on debt also increase because the probability of financial distress and bankruptcy increases with higher debt levels. This is because the higher the debt, the greater the firm's risk of defaulting on its obligations. Finally, the agency costs on equity decrease because as the risk of default increases with higher debt levels, equity holders have less to gain from taking on additional risk, and may therefore become more risk-averse.

When ﬁRms Issue More Debt, the Tax Shield on Debt