When additional borrowing causes the probability of financial distress to increase rapidly,the potential costs of distress begin to take a substantial bite out of firm value.

Question

Quizplus · Accepted Answer

This statement is true. As a firm takes on more debt, the probability of financial distress increases. If the level of debt becomes too high, the potential costs of distress (such as bankruptcy, debt restructuring, or liquidation) can outweigh the benefits of additional borrowing, and this can lead to a decline in firm value.

When Additional Borrowing Causes the Probability of Financial Distress to Increase