static trade off theory

The traditional view is as follows:
(a) As the level of gearing increases, the cost of debt remains unchanged up to a certain level of gearing. Beyond this level, the cost of debt will increase as interest cover falls, the amount of assets available for security falls and the risk of bankruptcy increases.
(b) The cost of equity rises as the level of gearing increases and financial risk increases.
(c) The weighted average cost of capital does not remain constant, but rather falls initially as the proportion of debt capital increases, and then begins to increase as the rising cost of equity (and possibly of debt) becomes more significant.
(d) The optimum level of gearing is where the company’s weighted average cost of capital is minimised.

Static trade-off theory states that firms in a static position will seek to achieve a target level of gearing by adjusting their current gearing levels. We know that a firm enjoys an increase in tax savings with an increase in debt financing due to the tax deductibility of interest. However, an increase in debt financing will also result in an increase in the chances of the firm going bankrupt because of its increased commitment in interest payments. This is the effect of financial leverage. It is important to remember that a firm can skip its dividend payments but not its interest payments. Failure to meet those interest payments because of inadequate cash on hand will cause the firm some financial distress, and the ultimate form of financial distress is bankruptcy.