Increasing Debt and Stock Price Relationship

The Impact of Debt on Stock Price

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Question

A firm initially has no debt in its capital structure. As it starts increasing its debt, the stock price begins to rise because of ________. After a threshold, an increase in debt reduces the stock price due to ________.

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A. B. C. D.

C

Debt offers tax shelter for income that equity does not since interest paid on debt is tax deductible. Therefore, as the firm starts adding debt to its capital structure in lieu of equity, the stock price starts rising. However, at a threshold debt-to-equity level, the higher probability of default offsets the value of the debt shield.

Beyond this, addition of more debt reduces the stock price.

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