Question

I am doing an exam review and just have some questions

Financial distress costs:

Select one:

-,May include impaired service to customers and suppliers and lost of trust

- Tend to offset the advantages of debt finance

- Might lower the value of the firm

- All of the above.

Keeping in mind that increasing the value of a firm is the goal of financial management, the trade-off theory shows that:

Select one:

- The corporate leverage decision involves a trade-off between the tax benefits of debt and the costs of financial distress

- There is an optimal amount of debt for any individual firm

- As more and more debt is added, the present value of the financial distress costs rises at a higher rate than the present value of the tax shield

- All of the above

Answer 1

Financial distress is a condition when promises to creditors of the company are broken or honored with difficulty. If this situation cannot be relieved it can lead to Bankruptcy. Financial distress may also lead to impaired service to customers and suppliers and lost of trust on the company, the value of the firm decreases and becomes difficult for a company to raise finance and thus Financial distress tend to offset the advantages of debt finance. thus last option (All of the above) is the right answer.

The Trade off theory of Capital Structure is the idea that company chooses how much debt finance & how much equity finance by balancing the costs and benefits.

It states that there is an advantage to financing with debt, the tax benefits and there are costs of financing with debt i.e, cost of financial distress including bankruptcy etc. There is an optimal amount of debt for any firm. The marginal benefits of increases in debt declines as the debt increases, while marginal cost increases. Thus in this case also the last option (All of the above ) is correct.