If the static theory of capital structure is true, then the optimal level of debt for a given firm increases as its marginal tax rate increases and decreases as the costs of financial distress increase.

Question

Quizplus · Accepted Answer

The static theory of capital structure suggests that firms balance the tax benefits of debt financing against the costs of financial distress. As the marginal tax rate increases, the tax shield from debt becomes more valuable, making higher levels of debt more attractive. Conversely, as the costs of financial distress increase, the drawbacks of debt become more significant, making lower levels of debt optimal.

If the Static Theory of Capital Structure Is True, Then