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CFA Level I · CFA Level I Exam · Capital Structure

Relative to the Modigliani-Miller propositions with corporate taxes, the static trade-off theory most likely concludes that the optimal capital structure is:

The static trade-off theory places the optimal structure where the marginal benefit of the interest tax shield equals the marginal expected cost of financial distress. This yields an interior debt level, unlike MM with taxes, which implies nearly all-debt financing.

  1. Aall-equity because of financial distress costs
  2. Bthe point where the marginal tax shield benefit equals the marginal expected distress costCorrect
  3. Calmost all debt because interest is tax deductible

Explanation

MM with taxes implies near 100% debt since the tax shield raises value. The static trade-off theory adds expected costs of financial distress, so value is maximized where the marginal benefit of the tax shield equals the marginal expected distress cost, giving an interior optimum. Neither extreme matches the theory.

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