Page 20 - FINAL CFA II SLIDES JUNE 2019 DAY 6

Static Trade-Off Theory
Seeks to balance the costs of financial distress with the tax shield READING 21: CAPITAL STRUCTURE
benefits from using debt.

MODULE 21.2: FACTORS AFFECTING CAPITAL STRUCTURE

There comes a point where the Implications for Managerial Decision Making
additional value added from the debt
tax shield is exceeded by the value- • MM’s propositions with no taxes: Capital structure
reducing costs of financial distress is irrelevant to firm value!
from the additional borrowing.
• MM’s propositions with taxes: Capital structure
is relevant as tax shield provided by interest
This point where the WACC is expense makes borrowing valuable, and WACC is
minimized and the value of the firm is minimized (and the value of the firm maximized) at
maximized.
100% debt (go gearing fully!
Accounting for the costs of financial distress, • Static trade-off theory recognizes tax shield but
the expression for the value of a levered firm also that increasing the use of debt also increases
becomes: the costs of financial distress up to a certain point.

V = V + (t × d) − PV(costs of financial • Managers will seek to balance the benefits of
L
U
distress) debt with the costs of financial distress and
identify an optimal capital structure.
LOS 21.b: Describe target capital structure and explain why a company’s actual capital structure may
fluctuate around its target.

Target (or optimal) capital structure is the structure that the firm uses over time when making decisions
about how to raise additional capital. It tends to fluctuate around the bottom of the U-share for 2 reasons:

• Management may choose to exploit opportunities in a specific financing source: For example, a
temporary rise in stock price may trigger new equity issue;

• Market value fluctuations: Because capital structure weights are determined by market values, these
fluctuations may cause the firm’s actual capital structure to vary from the target.