Final answer:
Adding more debt increases the present value of distress costs due to the higher risk of financial distress, affecting the cost of borrowing. The supply of financial capital could decline if the U.S. economy is viewed unfavorably, increasing interest rates. Higher interest rates result in a lower present value for future debt payments, devaluing investments in these debts.
Step-by-step explanation:
When more debt is added to a company's capital structure, the present value of distress costs typically increases. Distress costs refer to the costs that a company incurs when it faces financial distress or bankruptcy. As more debt is added, the likelihood of financial distress increases, leading investors to demand a higher return for the increased risk, which drives up the cost of borrowing for the company.
The supply of financial capital may be affected if the U.S. economy is seen as a less desirable place to invest due to increasing public debt. With higher debt levels, the U.S. government competes with businesses for financial resources, potentially subjecting businesses to higher interest rates. The increased competition for financial capital can lead to a spike in the cost of borrowing.
If the interest rates rise, the present value of future payments, such as those from bonds, is discounted at a higher rate. This results in a lower present value for the same set of future cash flows. Consequently, the value of investments holding these debts, such as bonds, decreases if investors try to sell them.