CFA Level II ExamCorporate IssuersMedium
A financial analyst is evaluating the optimal capital structure for a company, considering the trade-off between the tax shield benefits of debt and the costs of financial distress. The company operates in a stable industry with predictable cash flows. If the company increases its debt beyond a certain point, what is the most likely impact on its weighted average cost of capital (WACC)?
- AWACC will continue to decrease due to the increasing tax shield.
- BWACC will decrease initially, then increase, forming a U-shape.
- CWACC will remain constant as the benefits and costs perfectly offset.
- DWACC will increase due to the rising costs of financial distress.
Show answer & explanationAnswer & explanation
Correct answer: D. WACC will increase due to the rising costs of financial distress.
According to the static trade-off theory, beyond a certain optimal point, the increasing costs of financial distress (bankruptcy costs, agency costs, etc.) outweigh the tax shield benefits of debt, causing the WACC to rise. This is because the marginal cost of debt and equity increases significantly.
Why the other options are wrong
- A. The tax shield benefits diminish and are eventually outweighed by distress costs.
- B. This describes the overall shape of WACC, but the question asks about the impact *beyond* a certain point, implying after the minimum WACC has been reached.
- C. The benefits and costs do not perfectly offset indefinitely; distress costs eventually dominate.
Static Trade-off Theory
Proposes that a company's optimal capital structure involves a balance between the tax shield benefits of debt and the costs of financial distress.
- WACC is minimized at the optimal capital structure.
- Beyond optimal debt, financial distress costs outweigh tax benefits.
- Includes direct (bankruptcy) and indirect (agency) costs of distress.
Memory trick: Balance tax shields with distress, find the WACC's best.