Choose the blank:

Adding debt, the firm’s value will:

1. [ ] due to corporate taxes

2. [ ] due to bankruptcy costs

3. [ ] due to risk shifting and debt overhang that occur due to the agency problems between shareholders and debtholders

4. [ ] due to debt monitoring, reduction in agency problem between managers and shareholders

Question

Choose the blank:

Adding debt, the firm’s value will:

1. [              ] due to corporate taxes

2. [              ] due to bankruptcy costs

3. [              ] due to risk shifting and debt overhang that occur due to the agency problems between shareholders and debtholders

4. [              ] due to debt monitoring, reduction in agency problem between managers and shareholders

BlackTom AI · Accepted Answer

We start by unpacking the impact of adding debt on a firm's value across the four labeled effects.

Option 1: 'Increase, due to corporate taxes' — Here the statement attributes a value increase solely to the tax shield provided by debt. Indeed, interest payments are tax-deductible, which creates a tax shield and can raise firm value, but this option ignores the other costs and effects of debt (e.g., bankruptcy costs, agency problems) that may offset or even exceed the tax benefits in some cases. So while the tax shield can increase value, the claim is incomplete if it asserts only an increase with no caveats.

Option 2: 'Decrease, due to bankruptcy costs' — This option focuses on bankruptcy costs as the sole driver of value reduction. Bankruptcy costs indeed reduce value when debt levels are high, but debt also provides tax benefits and potential reductions in agency costs through monitoring and debt discipline. Therefore, stating a pure decrease ignores the simultaneous positive tax effects and potential monitoring benefits.

Option 3: 'Decrease, due to risk shifting and debt overhang that occur due to the agency problems between shareholders and debtholders' — Risk shifting and debt overhang are classic agency-cost mechanisms that can erode firm value when misaligned incentives between shareholders and debtholders prevail. These tend to reduce value, especially under debt overhang where new financing is discouraged and opportunities are passed up. However, this option isolates these agency problems as the sole or primary effect, omitting the tax shield and monitoring benefits that can counterbalance or offset these costs in many situations. Thus, while it captures a real channel of value loss, it is not the complete picture.

Option 4: 'Due to debt monitoring, reduction in agency problem between managers and shareholders' — Debt can improve governance by imposing debt covenants and signaling discipline, which reduces certain agency costs between managers and shareholders and can increase value through improved monitoring. Yet, this option emphasizes only the monitoring/agency cost reduction benefits and ignores the tax shield that typically adds value and the potential bankruptcy costs that can reduce value. Consequently, it presents an incomplete view if considered in isolation.

Putting the pieces together, the standard decomposition of how debt affects value includes: a positive tax shield that tends to increase value, negative bankruptcy costs that can decrease value, agency problems (like risk shifting and debt overhang) that can decrease value, and governance benefits from monitoring that can increase value. The combination that reflects both the positive and negative channels in the typical teaching is: Increase due to tax shield, Decrease due to bankruptcy costs, Decrease due to risk shifting/debt overhang, Increase due to debt monitoring reducing agency costs.

This aligns with the option that reads: 'Increase,Decrease, Decrease, Increase' (note the spacing after the comma in the provided correct answer).

FA25-BL-BUS-F305-1130 Final Exam

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