Question

3 By increasing debt in your company's capital structure, you are increasing your tax shield, but also increasing your financial distress costs.

True / False

Answer 1

True.

Increasing debt in capital structure is a trade off between the tax shield associated with interest payments on debt as well as financial distress cost.

Optimal level of debt is one where company is able to service the relevant interest expense associated with the debt without any distress. However, once the debt level cross this optimal level, it becomes increasingly difficult for company to service the timely payments associated with debt and might also lead to adding more debt to service liabilities associated with existing debt.

Shareholders also see a higher risk associated with higher debt and increase their required rate of return.

Thus, financial distress costs also rise and eclipse the benefits of tax shield post an optimal level of debt