CFA Level I · CFA Level I Exam · Capital Structure
According to the static trade-off theory of capital structure, as a firm increases its debt beyond the optimal level, the marginal benefit of the interest tax shield is most likely:
Under the static trade-off theory, additional debt beyond the optimal level brings expected costs of financial distress that rise faster than the tax shield benefit. The firm's value therefore falls past the optimum, and the optimal structure balances the two effects.
- Aoffset by rising expected costs of financial distressCorrect
- Bunaffected because distress costs depend only on equity
- Cmagnified because the cost of equity falls as leverage rises
Explanation
The trade-off theory balances the tax advantage of debt against the present value of expected financial distress costs. Beyond the optimum, the rising probability and cost of distress outweigh additional tax shield benefits. The cost of equity rises, not falls, with leverage.
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