As the level of debt increases, the value of the firm increases from the interest tax shield (TC xD) as well as improvements in managerial incentives. If leverage is too high, however, the present value of financial distress costs, as well as the agency costs from debt holderequity holder conflicts, dominates and reduces firm value. The optimal level of debt, D*, balances these benefits and costs of leverage.

Pick one of the following UNDERINVESTMENT PROBLEM PECKING ORDER THEORY AGENCY COST OF DEBT TRADEOFF THEORY