When graphing ﬁrm value against debt levels, the debt level that maximizes the value of the ﬁrm is the level where:
A)the increase in the present value of distress costs from an additional pound of debt is greater
Than the increase in the present value of the debt tax shield.
B)the increase in the present value of distress costs from an additional pound of debt is equal
To the increase in the present value of the debt tax shield.
C)the increase in the present value of distress costs from an additional pound of debt is less
Than the increase of the present value of the debt tax shield.
D)distress costs as well as debt tax shields are zero.
E)distress costs as well as debt tax shields are maximized.

Question

Quizplus · Accepted Answer

The optimal debt level is the level where the marginal benefit of debt equals the marginal cost of debt. The marginal benefit of debt is the increase in the present value of the debt tax shield, which increases as debt levels increase. The marginal cost of debt is the increase in the present value of distress costs, which also increases with debt levels. Therefore, the optimal debt level is where these two marginal effects are equal, which is described in choice B.

When Graphing ﬁRm Value Against Debt Levels, the Debt Level