Question

The point at which the tax saving from an additional dollar in debt financing is exactly balanced by the increased costs of bankruptcy associated with additional borrowing is the essence of the:

a) Dynamic theory of capital structure
b) Static theory of capital structure
c) Signaling theory
d) Hyperbolic theory of capital structure

Answer 1

The essence of the static theory of capital structure is finding an optimal debt-to-equity ratio where tax savings on debt are balanced with the costs of potential financial distress.

Step-by-step explanation:

The point at which the tax saving from an additional dollar in debt financing is exactly balanced by the increased costs of bankruptcy associated with additional borrowing describes the Static theory of capital structure. This theory posits that there is an optimal debt-to-equity ratio for a company where the marginal benefit of debt in the form of tax savings is equal to the marginal cost of debt, which includes the potential costs of financial distress and bankruptcy. According to this theory, companies should balance these costs and benefits to find the ideal capital structure that minimizes the overall cost of capital and maximizes firm value.