The static theory of capital structure states that the:
A) Debt-equity ratio of a ﬁrm is permanently ﬁxed.
B) Optimal ﬁrm value is reached when the tax beneﬁt from another dollar of debt is exactly offset by the ﬁnancial distress costs of that debt.
C) Value of a ﬁrm rises in a linear fashion in response to the pre-tax cost of debt.
D) Value of a ﬁrm rises every time the debt-equity ratio is increased.
E) Financial distress costs of a ﬁrm are constant.

Question

Quizplus · Accepted Answer

The static theory of capital structure states that the optimal debt-equity ratio of a firm is the one that maximizes the total value of the firm, where the tax benefit from another dollar of debt is exactly offset by the financial distress costs of that debt. Therefore, option B is the correct answer. The other options are not supported by the static theory of capital structure.

The Static Theory of Capital Structure States That The