CFA Level I · CFA Level I Exam · Capital Structure
Two firms have identical debt-to-equity ratios and tax rates. Firm X is a software company with mostly intangible assets and volatile earnings. Firm Y is a utility with tangible assets and stable cash flows. Under the static trade-off theory, which statement is most accurate?
Firm X, with intangible assets and volatile earnings, has higher expected costs of financial distress, so its optimal debt level is lower than the utility's. Identical tax rates fix only the benefit side; the distress cost side differs, so optimal debt differs.
- AFirm Y has a higher expected cost of financial distress and should use less debt
- BFirm X has a higher expected cost of financial distress and should use less debtCorrect
- CBoth firms have the same optimal debt level because tax rates are identical
Explanation
Intangible assets lose value quickly in distress and volatile earnings raise the probability of distress, so Firm X faces higher expected distress costs. This lowers its optimal debt ratio. Equal tax rates do not make the optima equal because the distress side of the trade-off differs.
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