As a firm increases its debt/asset ratio, the value of the firm initially increa

Question

As a firm increases its debt/asset ratio, the value of the firm initially increases, reaches a maximum point, and then decreases. Why does the value of a firm decrease beyond the maximum point?

A. If the firm whishes to raise more new capital beyond the optimal target, it must offer stock and bond investors lower rates of return.

B. The decision by the firm to use more debt beyond the optimal target causes an upward shift in the market line.

C.As the firm increases its debt ratio beyond the optimal target, it is required to pay higher taxes.

D. As the firm increases its debt ratio beyond the optimal target, marginal bankruptcy costs begin to exceed the marginal tax advantage of debt.

Explanation / Answer

D. As the firm increases its debt ratio beyond the optimal target, marginal bankruptcy costs begin to exceed the marginal tax advantage of debt.

Note : Theoretically, the debt rate where the marginal benefits of the tax shelter equal the marginal cost of increased bankruptcy risk dictates the optimal capital structure.

If the firm whishes to raise more new capital beyond the optimal target, it must offer stock and bond investors higher rates of return.

It is high degree of fiancial risk which demand higher equity capitalsation rate

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