LOS k: Explain and diagram the static trade-off theory of the optimal capital structure.

Q1. Bhairavi Patel, an analyst for major brokerage firm, is considering how to incorporate the static trade-off capital structure theory into her valuation models for companies she covers. Patel is discussing the static trade-off theory with her colleagues, and makes the following statements:

Statement 1: If a firm maintains a high debt rating, the firm cannot be at its optimal capital structure based on the static trade-off theory.

Statement 2: The static theory implies that differences in the optimal capital structure across similar firms in different countries must be the result of different tax rates in those countries.

With respect to Patel’s statements:

A)   both are correct.

B)   only one is correct.

C)   both are incorrect.

Q2. Katherine Epler, a self-employed corporate finance consultant, is working with another new client, Thurber Electronics. Epler is discussing the static trade-off capital structure theory with her client, and makes the following comments:

Comment 1: Under the static trade-off theory, the graph of a company’s weighted average cost of capital has a U shape.

Comment 2: According to the static trade-off theory, every firm will have the same optimal amount of debt that maximizes the value of the firm.

With respect to Epler’s comments:

A)   only one is correct.

B)   both are correct.

C)   both are incorrect.

Q3. According to the static trade-off theory:

A)   new debt financing is always preferable to new equity financing.

B)   there is an optimal proportion of debt that will maximize the value of the firm.

C)   the amount of debt used by a company should decrease as the company’s corporate tax rate increases.

Q4. Which of the following best describes the shape of the line depicting the value of a levered firm when plotted according to the static trade-off theory? Assume that the percentage of debt in the capital structure is the independent variable.

A)   U shaped.

B)   Upside down U shaped.

C)   Always upward sloping.

Q5. Global Development expects to earn $6 million next year. 40% of this amount, or $2.4 million, has been allocated for distribution to common shareholders. There are 2.4 million shares outstanding, and the market price is $30 a share. If Global uses the $2.4 million to repurchase shares at the current price of $30 per share, its share price after the repurchase will be closest to:

A)   $29.00.

B)   $30.00.

C)   $31.00.

LOS k: Explain and diagram the static trade-off theory of the optimal capital structure. fficeffice" />

Q1. Bhairavi Patel, an analyst for major brokerage firm, is considering how to incorporate the static trade-off capital structure theory into her valuation models for companies she covers. Patel is discussing the static trade-off theory with her colleagues, and makes the following statements:

Statement 1: If a firm maintains a high debt rating, the firm cannot be at its optimal capital structure based on the static trade-off theory.

Statement 2: The static theory implies that differences in the optimal capital structure across similar firms in different countries must be the result of different tax rates in those countries.

With respect to Patel’s statements:

A)   both are correct.

B)   only one is correct.

C)   both are incorrect.

Correct answer is C)         

Neither of Patel’s statements is correct. Firms seek to maintain a high debt rating because it implies a lower probability of financial distress, which reduces the cost of debt and equity capital and leads to a higher value for the firm. Although a firm would not be at its optimal capital structure if it were not using enough debt, a firm can certainly have a large proportion of high quality debt that keeps the firm at its optimal capital structure while maintaining a high credit rating. The second statement is also incorrect. Although differences in tax rates can play a role in having different optimal capital structures for similar firms, differences in costs of financial distress will play a role as well. Differences in legal structure, liquidity, and other factors will result in different perceived costs of financial distress in different countries, which will in turn, contribute to different optimal capital structures according to the static trade-off theory.

Q2. Katherine Epler, a self-employed corporate finance consultant, is working with another new client, Thurber Electronics. Epler is discussing the static trade-off capital structure theory with her client, and makes the following comments:

Comment 1: Under the static trade-off theory, the graph of a company’s weighted average cost of capital has a U shape.

Comment 2: According to the static trade-off theory, every firm will have the same optimal amount of debt that maximizes the value of the firm.

With respect to Epler’s comments:

A)   only one is correct.

B)   both are correct.

C)   both are incorrect.

Correct answer is A)

Epler’s first comment is correct. When graphing a company’s WACC according to the static trade-off theory, the WACC will initially decline as a company increases its tax savings through the use of debt. However, as more debt is added, the WACC will reach a point where it increases due to the increasing costs of financial distress. Note that when graphing the static trade-off theory, the WACC looks like a U shape, while the value of the firm looks like an upside down U shape. This makes sense because the value of the firm is maximized when the WACC is minimized. Epler’s second comment is incorrect. Every firm will have a different optimal capital structure that will depend on the firm’s operating risk, tax situation, industry influences, and other factors.

Q3. According to the static trade-off theory:

A)   new debt financing is always preferable to new equity financing.

B)   there is an optimal proportion of debt that will maximize the value of the firm.

C)   the amount of debt used by a company should decrease as the company’s corporate tax rate increases.

Correct answer is B)

The static trade-off theory seeks to balance the costs of financial distress with the tax shield benefits from using debt. Under the static trade-off theory, there is an optimal capital structure that has an optimal proportion of debt that will maximize the value of the firm.

Q4. Which of the following best describes the shape of the line depicting the value of a levered firm when plotted according to the static trade-off theory? Assume that the percentage of debt in the capital structure is the independent variable.

A)   U shaped.

B)   Upside down U shaped.

C)   Always upward sloping.

Correct answer is B)

The line depicting the value of a levered firm according to the static trade-off theory looks like an upside down U. The value of the firm will initially increase due to the tax savings provided by taking on additional debt financing, and then will decline as the costs of financial distress exceed the tax benefits of taking on additional debt financing.

Q5. Global Development expects to earn $6 million next year. 40% of this amount, or $2.4 million, has been allocated for distribution to common shareholders. There are 2.4 million shares outstanding, and the market price is $ffice:smarttags" />30 a share. If Global uses the $2.4 million to repurchase shares at the current price of $30 per share, its share price after the repurchase will be closest to:

A)   $29.00.

B)   $30.00.

C)   $31.00.

Correct answer is B)

Market value of equity before the repurchase is $30 × 2.4 million = $72 million.

Shares Repurchased = $2.4 million / $30 = 80,000 shares.

Shares remaining = Shares outstanding ? Shares repurchased = 2,400,000 ? 80,000 = 2,320,000.

Share price after the repurchase = ($72 million ? $2.4 million) / 2,320,000 = $30.

thanks