Question

According to the static theory of capital structure,

Select one:

a. the greater the volatility in EBIT, the less a firm should borrow.

b. the higher the financial costs, the less a firm should borrow.

c. the higher the accumulated losses, the less a firm should borrow.

d. the higher the tax rate, the more a firm should borrow.

e. all of the above are true.

Answer 1

All the given options are true. Hence Option E is the right answer.

A firm which is experiencing greater financial distress is more volatile and has more volatility in EBIT than other firms that are not experiencing this volatility. In this case, the firm should borrow less

Leverage helps the company to reduce WACC but it happens up to a certain point where the WACC is minimum. After that, the gain from leverage is offset by the increase in the cost of financing the capital structure of the company. Due to this, the higher the financial costs, the less a firm should borrow.

Similarly, if the losses are increasing, it would be difficult for the company to pay fixed obligations, therefore, it is better to reduce/ limit the fixed payment obligation. So, the firm should borrow less.

Leverage also provides tax benefits. Higher the tax rate, the more will be the incentives to borrow money.