Question

Which of the following expresses the value of a levered firm (VL) in the Static Tradeoff model of optimal capital structure [Note: VU denotes the value of the unlevered firm; CFD denotes expected costs of financial distress; and PV denotes present value.]

A. VL = PV(Tax Shield) - PV(CFD)

B. VL = VU + PV(Tax Shield) / PV(CFD)

C. VL = VU + PV(Tax Shield) - PV(CFD)

D. VL = VU + PV(Tax Shield)

Answer 1

C. VL = VU + PV(Tax Shield) - PV(CFD)

Step-by-step explanation:

The static trade off theory is a theory of capital structure in corporate finance, first proposed by Alan Kraus and Robert H. Litzenberger. The theory emphasizes the trade-offs between the tax benefits of increasing leverage and the cost of bankruptcy associated with higher leverage. The answer is C as we know relative to the unleveraged firm, leverage provides both costs and benefits. The benefits are the tax shields provided by debt.