Syllabus B. Advanced Investment Appraisal B3. Impact of financing on investment decisions and APV

B3h. Static trade­off theory 16 / 18

Syllabus B3h)

h) Assess the impact of financing and capital structure upon the organisation with respect to:

ii) Static trade-off theory

Static trade-off theory

Incorporate bankruptcy risk to M and M’s theory and you will arrive at the same conclusion as the traditional theory of gearing – i.e. that an optimal gearing level exists.

Firms can reach the optimum level by means of a trade­ off.

This is achieved by striking a balance between the benefits and the costs of raising debt.

Provided a company is in a static position ie not in a period of extreme growth, it is likely to have a gearing policy that is stable over time.

  1. Benefits of debt

    The benefits of debt relate to the tax relief that is enjoyed when interest payments are made – the cheaper debt finance will reduce the weighted average cost of capital and increase corporate value.

  2. Costs of debt

    The costs of debt relate to the increases in the costs of financial distress (eg bankruptcy costs) and increases in agency costs that arise when the company exceeds its optimum gearing levels. 

    The resultant increase in required returns demanded by investors cause the weighted average cost of capital of the company to increase and hence corporate value to fall.