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FRM Part II · FRM Exam Part II · Capital Structure in Banks

A bank's trade-off theory analysis shows that the tax shield benefit of an additional unit of debt falls as leverage rises, while the expected cost of financial distress rises. At the optimal capital structure, which condition holds?

At the optimum under trade-off theory, the marginal tax shield benefit from additional debt equals the marginal expected cost of financial distress. Beyond this point added leverage reduces value, and before it added leverage raises value.

  1. AThe marginal tax shield benefit of debt equals the marginal expected distress costCorrect
  2. BTotal tax shield benefit equals total distress cost
  3. CDistress costs are zero
  4. DThe cost of equity equals the cost of debt

Explanation

Optimal leverage maximises firm value where the marginal benefit of one more unit of debt equals its marginal expected cost of distress. Total benefit equal to total cost does not maximise value.

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