Question

As a firm takes on more debt, its probability of bankruptcy ________. Other factors held constant, a firm whose earnings are relatively volatile faces a _______ chance of bankruptcy. Therefore, when other factors are held constant, a firm whose earnings are relatively volatile should use _______ debt than a more stable firm. When bankruptcy costs become more important, they ______ the tax benefits of debt.

Answer 1

increases

greater

less

reduce

Step-by-step explanation:

As a firm takes on more debt, its probability of bankruptcy increases.Other factors held constant, a firm whose earnings are relatively volatile faces a greater chance of bankruptcy. Therefore, when other factors are held constant, a firm whose earnings are relatively volatile should use less debt than a more stable firm. When bankruptcy costs become more important, they reduce the tax benefits of debt.

An increase in debt increases the gearing of an entity and exposes a firm to possible bankruptcy if the debt are not properly managed.

Volatility of earnings means unpredictable earnings stream, when earnings are unpredictable, it exposes a firm to bankruptcy. A firm with volatile earnings should reduce the gearing ratio.

Debt gives some tax advantages and when a firm reduces its debt, such tax advantages of debt is eroded.