The inclusion of bankruptcy costs and taxes in firm valuation

Question

Quizplus · Accepted Answer

The inclusion of bankruptcy costs and taxes leads to the saucer-shaped cost of capital curve. This is because at lower levels of debt, the tax shield from interest payments outweighs the costs of financial distress, resulting in a lower cost of capital. However, at higher levels of debt, the costs of financial distress begin to outweigh the tax benefits, leading to an increase in the cost of capital.

The Inclusion of Bankruptcy Costs and Taxes in Firm Valuation