Practice Question
What is the impact on the value of a firm if it issues debt instead of equity, assuming all else remains constant?
Answer +
A
Explanation +
Issuing debt can increase the value of a firm because interest payments on debt are tax-deductible. This tax shield reduces the firm's taxable income and, consequently, its tax liability. As a result, the after-tax cost of debt is lower than the cost of equity, potentially boosting the firm's value if used appropriately. However, excessive debt can increase financial risk.