CFA Level II ExamCorporate IssuersMedium
A company is considering its optimal capital structure. The CFO is analyzing various combinations of debt and equity financing. According to the static trade-off theory, what is the primary factor that limits a company's ability to increase its value by taking on more debt beyond a certain point?
- AThe agency costs associated with greater debt financing.
- BThe increasing probability and cost of financial distress.
- CThe increasing cost of equity due to higher financial risk.
- DThe diminishing marginal benefit of the debt tax shield.
Show answer & explanationAnswer & explanation
Correct answer: B. The increasing probability and cost of financial distress.
The static trade-off theory posits that a company's optimal capital structure balances the tax benefits of debt against the costs of financial distress. Beyond a certain point, the increasing probability and costs (direct and indirect) of financial distress outweigh the benefits of the debt tax shield, leading to a decrease in firm value.
Why the other options are wrong
- A. Agency costs are a factor, but the static trade-off theory specifically highlights financial distress costs as the main counterweight to the debt tax shield.
- C. While the cost of equity does increase, the static trade-off theory focuses on the overall firm value, which is driven by the balance of debt benefits and distress costs.
- D. The marginal benefit of the debt tax shield may diminish, but the primary offsetting factor leading to decreased firm value is the cost of financial distress.
Static Trade-off Theory
The static trade-off theory suggests an optimal capital structure exists where the marginal benefit of the debt tax shield equals the marginal cost of financial distress.
- Balances tax benefits of debt against costs of financial distress.
- Predicts an optimal debt-to-equity ratio that maximizes firm value.
- Costs of financial distress include direct (legal, administrative) and indirect (lost sales, employee turnover) costs.
Memory trick: Capital's Core: Trade-offs & Pecking.