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If a firm went from zero debt to successively higher levels of debt, why would you expect its...

Question:

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?

Debt Issue:

The issuance of debt or the usage of debt for a company has a large number of benefits. Withing a given limit, the benefits of the debt far outweigh the disadvantages of the debt.

Answer and Explanation:

When the firm issued debt initially, there are considerable tax savings because the interest is tax-deductible. These savings increase as more debt in included. This leads to greater profitability and hence the stock prices rise. However, beyond a certain level of debt, the risk of using debt i.e. distress costs increases and the risk from debt outweighs the benefits. This leads to stock price decreasing as more debt is added.


Learn more about this topic:

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Long-Term Debt: Definition, Cost & Formula

from Financial Accounting: Help and Review

Chapter 8 / Lesson 7
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