At some debt-equity ratio, the costs of financial distress are expected to overcome the value of the interest tax shield for a firm.

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Quizplus · Accepted Answer

This is known as the "optimal capital structure" concept, and it suggests that there is a point where increasing debt levels result in higher expected costs of financial distress (such as bankruptcy), which outweigh the benefits of the interest tax shield. Therefore, companies should aim to find the debt-equity ratio that maximizes their overall value.

At Some Debt-Equity Ratio, the Costs of Financial Distress Are