Question

If the present value of the tax shield equals the present value of the costs of financial distress, then the:
A. Firm should increase its use of debt.

B. Firm is using the optimal level of debt.
C. Firm is paying too high an interest rate.
D. Firm’s market value equals the value of the unlevered firm.

.

Answer 1

Key Points:

• The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits.
• The trade-off theory states that the optimal capital structure is a trade-off between interest tax shields and cost of financial distress

So, Option B) Firm is using the optimal level of debt is correct

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