As the level of debt increases,the tax benefits of debt increase until:

Question

Quizplus · Accepted Answer

The tax benefits of debt increase as the level of debt increases because the interest payments on debt are tax-deductible. This means that the higher the level of debt, the more the firm can reduce its taxable income and therefore, the amount of tax it pays. However, at a certain point, the costs associated with financial distress (such as bankruptcy costs or costs associated with defaulting on debt) may outweigh the tax benefits of debt. Thus, the point at which the tax shield benefit exceeds distress costs represents the optimal level of debt for the firm.

As the Level of Debt Increases,the Tax Benefits of Debt