According to the static tradeoff model of capital structure,in a world with taxes,firms have an incentive:
A) to issue debt as this will always reduce the weighted average cost of capital.
B) to issue debt until the benefits from the tax savings equals the costs of financial distress.
C) to maximize the amount of debt.

Question

Quizplus · Accepted Answer

The static tradeoff model suggests that firms have an incentive to use debt financing due to the tax shield benefit it provides. However, there are costs associated with financial distress (e.g. bankruptcy costs) which increase with the amount of debt used. Therefore, firms should not maximize debt, but rather choose a level of debt that balances the benefit from tax savings with the costs of financial distress. This optimal level of debt is reached when the marginal benefit of issuing more debt (tax savings) equals the marginal cost (financial distress).

According to the Static Tradeoff Model of Capital Structure,in a World