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. Consequently, the risk associated with the tax shield (resulting from interest paid on outstanding debt) is the same as that associated with the firm.

Question

Quizplus · Accepted Answer

When the level of debt is perfectly correlated with the firm's market value, the risk associated with the tax shield is also perfectly correlated with the firm's overall risk. Therefore, the statement is true.

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