When the firm increases its debt in direct proportion to the market value of its equity, the level of the debt is perfectly correlated with the firm's market value.

Question

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When the firm increases its debt in direct proportion to the market value of its equity, the resulting level of debt is perfectly correlated with the firm's market value. This is because as the market value of equity increases, the firm can issue more debt, resulting in a higher level of debt that is perfectly correlated with the firm's market value.

When the Firm Increases Its Debt in Direct Proportion to the Market