The optimal capital structure occurs when:
A) additional borrowing results in lower financial distress costs.
B) additional borrowing is offset by the interest tax shield.
C) the tax savings from additional leverage are offset by the increased costs of distress.
D)the present value of the tax shield exceeds the value of the all-equity-financed firm.

Question

Quizplus · Accepted Answer

The optimal capital structure occurs when the tax benefits from additional leverage are balanced by the increased costs of financial distress. This means that the benefits of using debt, such as the interest tax shield, are offset by the potential risks associated with having too much debt. If a company borrows too much, financial distress costs (e.g. bankruptcy, costs of restructuring) increase, outweighing any benefits from using debt. Therefore, choice C is the best answer.

The Optimal Capital Structure Occurs When