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

Solution :

The trade-off theory says that the optimal capital structure is a trade-off between interest tax shields and cost of financial distress.

• If we get the higher tax shield due to Increase in interest payment then distress will increase due to the burden of debt.

This theory says that the value of the levered firm will be equal to the value of an unlevered firm + The firm is enjoying the tax shield on the interest payment - The firm will be facing some cost due to increase in debt burden.

So effectively

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

Option C is the correct answer