Static trade-off theory
Debt can create value through interest tax savings, but additional gearing can increase the probability and consequences of distress, constrain operations and create agency costs. The trade-off approach seeks a capital structure at which the marginal benefit of further debt is balanced by marginal expected costs. The result varies with cash-flow stability, assets, taxes and financing conditions. It is not a precise formula that identifies one permanent universal gearing ratio, and it differs from the pecking-order explanation based on preferences and information effects.
Worked example
A stable utility with predictable cash flows and substantial assets may sustain more borrowing than a volatile young research business. Different expected distress costs can justify different target gearing even if both face the same headline tax rate.
Common mistake
Assuming a high tax rate alone determines an optimal debt level without considering the ability to use relief or the consequences of distress.
Where it appears in your exams
| Qualification | Exam | Relationship | Period |
|---|---|---|---|
| ACCA | AFM | Direct | September 2026–June 2027 |
| ACCA | FM | Direct | September 2026–June 2027 |