Question

1. According to the Static Tradeoff Theory, how should today’s low interest rate environment (10-year Treasury Bond Rates are less than 1%/year) impact corporations’ optimal D/A ratios? Explain!

Answer 1

Static trade off theory is based on Modigliani and Miller propositions with taxes which says taking levereage will increase the value of the firm and is given by the equation VL= VU + D*Taxrate ; VL= value of levered firm ;

VUL=value of unlevered firm ; D=Debt

Stati traeoff theory states that the risk of taking a debt over equity is initially lower than the equity financing due to the presence of tax shield. Implies a company can lower the WACC through increasing D/E ratio. However as the ratio of debt to increase the risk associated to the company increases which offsets the WACC. Static tradeoff theory identifies the balance between debt and equity considering the risk tradeoff.

If the treasury yields are lowered; it means that the cost of debt will be lowered by the banks. This means that the company's risk exposure to debt will be lower than before. Hence according to Static treadeoff theory it is suggested to borrow more money and change the capital structure until the previous optimum WACC and risk position are achieved.