CFA Level I · CFA Level I Exam · Capital Structure
In the static trade-off theory of capital structure, the costs of financial distress are most likely:
Under static trade-off theory, the expected costs of financial distress are weighed against the tax benefit of debt. The optimal capital structure is reached where the marginal tax shield benefit equals the marginal increase in expected distress costs, so distress costs are not ignored and do not fall with leverage.
- AOffset against the tax shield of debt to locate an optimal debt level.Correct
- BIgnored because debt is always cheaper than equity.
- CReduced as a firm raises its debt-to-equity ratio.
Explanation
Static trade-off theory balances the present value of the interest tax shield against the expected costs of financial distress. The optimal debt level is where the marginal benefit of the tax shield equals the marginal expected distress cost. Distress costs rise, not fall, with leverage, and they are not ignored.
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