A trade-off between the benefits of debt finance and the costs of financial distress may lead to a company increasing its debt/equity ratio because:
A)of the low probability of encountering severe financial difficulties.
B)its existing debt/equity ratio is high.
C)the expected increase in financial distress is expected to outweigh the tax benefits.
D)agency costs of equity increase as the level of debt increases.

Question

Quizplus · Accepted Answer

If the probability of severe financial difficulties is low, the benefits of debt finance, such as tax advantages and increased leverage, may outweigh the potential costs of financial distress. Therefore, the company may choose to increase its debt/equity ratio to capitalize on these benefits. Options B, C, and D are not correct because they do not necessarily provide a rationale for increasing the debt/equity ratio based on a trade-off between benefits and costs.

A Trade-Off Between the Benefits of Debt Finance and the Costs