When both the tax deductibility of debt and the present value of potential bankruptcy costs are included,the cost of capital for a firm tends to:

Question

Quizplus · Accepted Answer

As the level of debt increases, the tax deductibility of debt lowers the cost of capital. However, at some point, the present value of potential bankruptcy costs becomes significant and causes the cost of capital to increase. Therefore, the cost of capital decreases up to some debt-value ratio, then increases as bankruptcy costs become significant.

When Both the Tax Deductibility of Debt and the Present