$2$ points$)$ Acme Corp. is considering shifting its capital structure from an equity$-$only financed

firm to a mixed debt$-$equity financed firm. The management believes that incorporating debt

financing could create value due to certain market imperfections. However, they are concerned

about potential trade$-$offs involving financial distress costs, tax shields, agency conflicts, and

signaling effects. Which of the following scenarios best illustrates the complex interactions

described by both the trade$-$off theory and signaling theory in capital structure decisions?

$($a$)$ Acme Corp. decides to issue debt to repurchase equity, taking advantage of the tax

deductibility of interest. However, investors interpret the debt issuance as a signal of

future profitability, pushing up stock prices despite higher distress risk.

$($b$)$ Acme Corp. decides against debt financing because management fears debt may encour$-$

age overly conservative investment behavior, reducing risk$-$taking and firm value despite

tax shield benefits.

$($c$)$ Acme Corp. adds debt to lower its weighted average cost of capital $($WACC$).$ Investors

interpret debt as signaling managerial pessimism regarding future profitability, causing

the stock price to decline and negating tax shield advantages.

$($d$)$ Acme Corp. issues debt, reducing its agency costs by imposing stricter financial dis$-$

cipline. However, the resulting increased leverage increases perceived bankruptcy risk,

offsetting the tax shield and resulting in a neutral net valuation impact.

$1$

$($e$)$ Acme Corp. raises debt capital, decreasing information asymmetry by signaling strong

managerial confidence. Nevertheless, the higher leverage leads to restrictive covenants,

limiting future investment opportunities and offsetting benefits from lower capital costs.