CFA Level I · CFA Level I Exam · Capital Structure
Compared with the static trade-off theory's prediction at the optimal capital structure, a firm that has raised debt well beyond that optimum is most likely to experience:
Beyond the optimal debt level, expected distress costs exceed the added tax shield, so the weighted average cost of capital rises and firm value falls. The cost of equity also rises with leverage, and the benefit and cost offset only at the optimum.
- Aa lower cost of equity because debt is cheaper than equity
- Ba higher weighted average cost of capital and a lower firm valueCorrect
- Can unchanged firm value because the tax shield offsets distress costs
Explanation
Beyond the optimum, the marginal expected distress costs exceed the marginal tax shield, so the WACC rises and firm value falls. The cost of equity rises, not falls, with leverage. The two effects offset only at the optimum, not beyond it.
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