Financial Distress and Capital Structure Decisions

Hard Capital Structure Decisions Financial Distress

Consider a firm that is experiencing financial distress due to a significant decline in its operating revenues. The management is debating whether to restructure its capital to improve its financial health. They are exploring the impact of increased debt on the firm's future cash flows and its optimal capital structure.

Which of the following statements best captures the relationship between financial distress costs and capital structure decisions in this context?

Increasing the level of debt enhances the bankruptcy risk but may lead to lower costs of capital, as firms operating under financial distress may have tax shields that compensate for the risk.

Higher levels of debt reduce the firm's flexibility and can significantly increase the expected bankruptcy costs, leading to a higher weighted average cost of capital (WACC).

While increasing equity financing decreases overall leverage and bankruptcy risk, it also diminishes the financial distress costs without affecting the firm’s optimal capital structure.

Hint

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