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CFA Level I · CFA Level I Exam · Capital Structure

According to the static trade-off theory of capital structure, the optimal level of debt for a firm is most likely reached at the point where:

The optimal debt level is where the marginal tax benefit of extra debt equals the marginal increase in expected costs of financial distress. Beyond that point, added distress costs outweigh the interest tax shield, so firm value falls and the WACC rises.

  1. Athe marginal tax benefit of additional debt equals the marginal increase in expected costs of financial distressCorrect
  2. Bthe weighted average cost of capital equals the cost of equity
  3. Cthe firm's interest expense equals its earnings before interest and taxes

Explanation

The static trade-off theory balances the tax shield benefit of debt against the expected costs of financial distress. Value is maximized, and the WACC minimized, where the marginal benefit equals the marginal cost. The WACC equalling the cost of equity would imply no debt, which is not the optimum.

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