CFA Level I · CFA Level I Exam · Capital Structure
According to static trade-off theory, beyond the optimal debt level, an additional unit of debt most likely:
Beyond the optimal debt level, extra debt lowers firm value because the marginal expected cost of financial distress is greater than the marginal present value of the interest tax shield. The net effect of more leverage is negative from that point.
- ARaises firm value because interest is tax deductible.
- BLowers firm value because the added expected distress cost exceeds the added tax shield.Correct
- CLeaves firm value unchanged because of offsetting equity costs.
Explanation
Past the optimum, the marginal increase in expected distress costs exceeds the marginal tax shield, so value falls. Value is only unchanged in the Modigliani-Miller no-tax, no-cost case.
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