When graphing firm value against debt levels,the debt level that maximizes the value of the firm is the level where:
A) the increase in the present value of distress costs from an additional dollar of debt is greater than the increase in the present value of the debt tax shield.
B) the increase in the present value of distress costs from an additional dollar of debt is equal to the increase in the present value of the debt tax shield.
C) the increase in the present value of distress costs from an additional dollar of debt is less than the increase of the present value of the debt tax shield.
D) distress costs as well as debt tax shields are zero.
E) distress costs as well as debt tax shields are maximized.

Question

Quizplus · Accepted Answer

The level of debt where the increase in the present value of distress costs from an additional dollar of debt is equal to the increase in the present value of the debt tax shield is where the firm value is maximized. This is because at this point, the benefits of the debt tax shield are offset by the costs of financial distress. Beyond this point, the costs of financial distress outweigh the benefits of the debt tax shield, leading to a decrease in firm value.

When Graphing Firm Value Against Debt Levels,the Debt Level That