Bankruptcy risk negatively affects the value of a firm. Firstly, the before-tax cost of debt increases which makes debt financing more costly. Secondly, the stockholders who hold residual claims in sharing the earnings and assets of the company demand a higher yield. Since creditors have a priority in their claims, higher debt ratios and the rising probability of bankruptcy heighten the risk borne by the stockholders. As a result, the cost of the funds raised by the company, no matter debt or equity upsurge, raises the weighted average cost of capital (WACC). The value of the firm declines as the bankruptcy risk rises since the free cash flows (FCF) drop with the loss of confidence in the firm. Another problem that is caused by the rising bankruptcy risk is the underinvestment in positive NPV projects. The correct answer is A.