What effect is the risk of financial distress likely to have on the level of optimal gearing of a firm from the point of view of shareholders' value maximisation?
A) It will encourage managers to gradually increase the level.
B) It will have little effect.
C) It will moderate the level of gearing.
D) It will increase the level of gearing.

Question

Quizplus · Accepted Answer

The risk of financial distress is likely to moderate the level of gearing, as shareholders will not want the level of debt to be so high that it significantly increases the risk of bankruptcy or default. Therefore, shareholders will tend to prefer a more moderate level of gearing that balances the benefits of tax shields against the costs of financial distress.

What Effect Is the Risk of Financial Distress Likely to Have