CFA Level I · CFA Level I Exam · Capital Structure
According to the static trade-off theory, the optimal capital structure is most likely reached at the debt level where:
The optimum occurs where the marginal tax benefit of additional debt equals the marginal expected cost of financial distress. Before that point extra debt adds value through interest tax shields; beyond it, distress costs outweigh the shield, so WACC is minimized at the balance point.
- Athe marginal tax benefit of debt equals the marginal expected cost of financial distressCorrect
- Bthe firm has no debt, to eliminate financial distress costs
- Cthe cost of equity equals the pre-tax cost of debt
Explanation
Static trade-off theory balances the tax shield benefit of interest against rising expected costs of financial distress. The optimum is where the marginal benefit equals the marginal cost, which minimizes WACC and maximizes value.
Did you get it right without looking?
One question tells you little. A timed set on Capital Structure shows your real accuracy, how long you take and where you lose marks.
More Capital Structure questions
- Under Modigliani-Miller Proposition II without taxes, as a firm increases its debt-to-equity ratio, the cost of equity most likely:
- A firm has a marginal tax rate of 25% and currently has debt of 400 at a 6% interest rate. Under the static trade-off theory, the firm's ann…
- According to static trade-off theory, beyond the optimal debt level, an additional unit of debt most likely:
- Which of the following is most likely an indirect cost of financial distress?
- Which action by a company's managers would most likely be interpreted by investors as a credible positive signal about future prospects?
- A company announces a large issuance of new common shares to fund expansion. Under signaling theory and information asymmetry, the share pri…