Final answer:
The student's question pertains to the optimal point at which a firm should employ debt in its capital structure according to the static theory. The answer is that debt should be employed until the cost of debt equates to the tax shield benefits it provides. It's important for firms to balance the benefits of a tax shield against the risk of financial distress when considering debt financing.
Step-by-step explanation:
The student has asked about the static theory of capital structure, specifically at what point a firm should employ debt. According to the static theory, one should employ debt up to the point where the cost of debt equals the tax shield of debt. The tax shield refers to the tax savings a firm achieves by incurring debt, as the interest payments on debt are tax deductible. Therefore, the correct answer is c) The tax shield of debt.
Firms often have to decide between different methods of financing, such as borrowing from banks, issuing bonds, or issuing stock. Each method has its advantages and disadvantages. For instance, borrowing money allows a firm to maintain control, as it does not involve giving up ownership like when issuing stock. However, borrowed funds do commit the firm to scheduled interest payments whether or not they have sufficient income. This is not the case with equity financing, where payments to shareholders typically come from profits.
It is also worthy to note that a firm's capital structure can influence both its risk and value. The use of excessive debt increases the likelihood of bankruptcy, but also provides a tax shield that can benefit the firm's value.