If a firm went from zero debt to successively higher levels of debt, why would you expect its stock price to first rise, then hit a peak, and then begin to decline?
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If a firm went from zero debt to successively higher levels of debt, why would you expect its stock price to first rise, then hit a peak, and then begin to decline? |
Explanation
Increase in the level of debts will lead to initial increase in stock price and firm's value due to the tax benefits as tax benefits lead to increase in the stock price because less tax has to be paid and more income can be distributed to debt holders.
But as more and more debt is employed then the stock price and firm's value starts decreasing because this shows that the firm depends more on debt rather than equity and will have to pay these debts in future leading to decreased value of stock price.
Verified Answer
Increase in debt will lead to increase in stock price and firm's value eventually because return on capital equity will improve and starts decreasing afterwards as financial distress will be higher.
