Question

According to the Static Tradeoff Theory, issuing debt has costs and benefits. Describe these costs and benefits associated with debt financing.

Based on this theory, explain how the new tax law, that lowers corporate income tax rates, will impact the level of corporate borrowing.

Answer 1

As per the static trade-off theory costs associated with debt includes the cost of bankruptcy. The theory states that debt is associated with increased probability of bankruptcy and this leads to increased cost of failure. Another cost associated with debt, as per the static trade-off theory, is the agency costs. This is because use of debt leads to agency conflicts between shareholders and creditors. In terms of benefits the static trade-off theory states that debt leads to tax savings as interest paid is a tax deductible expense. Thus the primary benefit of debt is that it is cheaper than equity financing, thanks to the tax advantages associated with it.

The new tax law that lowers corporate income taxes will reduce the level of corporate borrowing. This is because, and as per the static trade-off theory, with a decrease in corporate income taxes the benefits associated with the use of debt will fall and hence cost of bankruptcy will become stronger. Lower tax rates will not enable a company to lower its WACC (weighted average cost of capital) through use of debt and hence its use of debt will decline in its capital structure.