Sheila makes two comments regarding the static tradeoff theory. Comment 1: “As the proportion of debt...
Sheila makes two comments regarding the static tradeoff theory.
Comment 1: “As the proportion of debt in a firm rises, the value of the levered firm initially rises and then falls.”
Comment 2: “As the proportion of debt in a firm rises, its after-tax cost of debt initially falls and then rises.”
Are Sheila’s comments about the static tradeoff theory correct?
Homework Answers
Comment 1 is correct.
As leverage increases, the value of the levered firm initially rises, till the time capital structure reaches an optimal level. Increasing debt further leads to the cost of distress and probability of bankruptcy, thereby increasing the cost of capital and reducing the value of the firm.
Comment 2 is not correct
Leverage leads to additional risk and hence cost of debt also increases as leverage increases. As the proportion of debt in a firm rises, its after-tax cost of debt also rises. Hence, the given statement is not correct.
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Sheila makes two
comments regarding the static tradeoff theory.
Comment
1: “As the proportion of debt...
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