At its current debt level, a firm estimates that issuing one additional dollar of debt would increase the present value of its interest tax shield by $0.30, but increase the present value of expected financial distress costs by only $0.10. According to the tradeoff theory, what should the firm do?

Question

BlackTom AI · Accepted Answer

The marginal benefit of debt is the present value (PV) of the interest tax shield; the marginal cost is the PV of expected financial distress. Tradeoff theory says a firm should increase leverage while marginal benefit > marginal cost, and stop when they are equal.

1) Relevant knowledge and concepts
- Tradeoff theory of capital structure: firms balance tax shield benefits of debt against expected costs of financial distress and bankruptcy.  
- Marginal decision rule: issue additional debt if marginal PV(benefit) > marginal PV(cost); reduce debt if marginal cost > marginal benefit.  
- Marginal value change per dollar of debt = PV(tax shield per $1) − PV(expected distress cost per $1).

2) Step-by-step reasoning
- The firm estimates that for each additional $1 of debt: PV(interest tax shield) = $0.30; PV(expected financial distress costs) = $0.10.  
- Compare marginal benefit to marginal cost: 0.30 versus 0.10. Since 0.30 > 0.10, the marginal benefit of another dollar of debt exceeds its marginal cost.

3) Calculations (intermediate steps)
- Marginal net benefit per $1 = PV(tax shield) − PV(distress)  
- = $0.30 − $0.10  
- = $0.20 net increase in firm value per $1 of new debt.

4) Why the correct answer is correct
- Because the net marginal effect is positive (+$0.20), increasing debt raises firm value at the margin. Under tradeoff theory the firm should therefore increase leverage until marginal benefit declines or marginal cost rises to equality.

5) Why the other options are incorrect (brief)
- "Increase debt indefinitely" is wrong: marginal benefits will eventually fall or costs rise; equilibrium exists.  
- "Reduce debt" is wrong because costs do not exceed benefits here.  
- "Issue only equity" is irrelevant and ignores the positive tax shield net of distress costs.  
- "Keep debt unchanged" is wrong because tradeoff-relevant net benefit is nonzero and suggests adjustment.

6) Conclusion
The firm should increase debt; the estimated marginal increase in firm value is $0.20 per dollar of additional debt, which matches the provided correct answer.

Similar Questions

According to the tradeoff theory of capital structure, which firm is most likely to operate with the highest leverage ratio?

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According to Modigliani and Miller, in a world with no corporate taxes a firm cannot change its total value by altering the proportions of debt and equity in its capital structure.

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Modigliani and Miller (MM) won Nobel Prizes for their work on capital structure theory.

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