Describe the Static Theory of Capital Structure
What will be an ideal response?
Answer: The Static Theory of Capital Structure posits an optimal capital structure. An optimal capital structure or debt/equity ratio occurs at the point where the additional tax-shield benefit of adding one more dollar of debt financing is equal to the direct and indirect cost of bankruptcy from that extra dollar of debt. Beyond this point, adding one more dollar of debt financing makes the equity holder worse off. Thus, the Static Theory of Capital Structure balances the benefits and the costs of debt financing at the optimal debt-equity ratio. This theory separates the investment decisions of the firm from its financing decisions. So, once the assets and operations are fixed (static), we then consider the optimal way to finance the firm.
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