When firms issue more debt,the tax shield on debt _____,the agency costs on debt (i.e.,costs of financial distress) _____,and the agency costs on equity _____.
A) increases; increase; increase
B) decreases; decrease; decrease
C) increases; increase; decrease
D) decreases; decrease; increase
E) increases; decrease; decrease

Question

Quizplus · Accepted Answer

When firms issue more debt, the tax shield on debt increases since interest payments are tax-deductible, reducing the overall tax liability of the firm. However, the agency costs on debt (i.e., costs of financial distress) increase as the firm becomes more indebted, increasing the likelihood of default and bankruptcy, which can be costly. On the other hand, the agency costs on equity decrease as the level of debt increases because debt reduces the free cash flow available to managers, who may use it to pursue their own interests at the expense of shareholders.

When Firms Issue More Debt,the Tax Shield on Debt _____,The