The inclusion of financial distress costs in firm valuation:
A)acknowledges that a firm is insulated from the impact of high debt financing.
B)provides a rationale for a saucer-shaped cost of capital curve.
C)eliminates conflicts between bondholders and stockholders.
D)causes the cost of capital to rise in a linear fashion as more debt is added to the capital structure.

Question

Quizplus · Accepted Answer

Financial distress costs refer to the costs associated with a firm facing bankruptcy or default due to high debt levels. Including these costs in firm valuation provides a rationale for a saucer-shaped cost of capital curve, where the cost of capital initially decreases with increasing debt but eventually starts to rise due to the increased risk of financial distress. This concept is important in determining the optimal capital structure for a firm.

The Inclusion of Financial Distress Costs in Firm Valuation