In Modigliani and Miller's model with taxes and bankruptcy costs, value increases with leverage due to the "tax shield" created by interest payments. However, this effect is eventually offset by higher risk and investor concerns about bankruptcy losses should the firm fail.

Question

Quizplus · Accepted Answer

In Modigliani and Miller's model with taxes and bankruptcy costs, value increases with leverage due to the "tax shield" created by interest payments. However, as the firm takes on more debt and becomes riskier, the benefit from the tax shield is eventually offset by higher bankruptcy costs and investor concerns about potential losses. Therefore, there is an optimal level of leverage that maximizes the overall value of the firm.

In Modigliani and Miller's Model with Taxes and Bankruptcy Costs