A firm has level coupon debt outstanding and growth opportunities.
A) The firm should be 100% debt financed because the greater the debt the greater tax shield.
B) 100% debt financing is suboptimal because increased firm value does not increase the current interest needed to shield income today.
C) Firm value will only increase if the debt level is increased to 100%.
D) The high growth firm will have high debt ratios as they need greater financing.

Question

Quizplus · Accepted Answer

While it is true that a greater level of debt can result in a greater tax shield, 100% debt financing is suboptimal for a firm with growth opportunities. This is because increased firm value does not necessarily result in an increase in the current interest needed to shield income today. Additionally, high levels of debt can increase financial risk for the firm. Thus, a mix of debt and equity financing would be more appropriate for a firm with growth opportunities.

A Firm Has Level Coupon Debt Outstanding and Growth Opportunities