Explain the static theory of capital structure using the gra

Explain the static theory of capital structure using the graph below. Describe the meaning of each term (RU, RE, WACC*, RDx(1-Tc), and D*/E*) on the graph below.

Cost of capital Re Ru WACC Minim um cost of capital (WACC*) Ro x (1-TC) Debt-equity ratio D/E Optmal debt- equity ratio

Solution

Static theory of capital structure states that a firms capital structure is determined by a \"tradeoff of the value of tax shields against the costs of bankruptcy.\"

It states that although debt is cheaper source of capital howver including more debt in the capital structure gives rise to increasing probability or costs or bankrupcy and thus the optimal capital structure (D*/E*) is which balances the bankrupcy costs and the tax benefits of the debt.

RE- is the return on equity
WACC* is minimum cost of capital when the capital structure has only debt
R_D(1-T_c) is the debt cost after tax.

D*/E* is the optimal capital structure
WACC is the weighted average cost of capital at different capital structure as shown by the curve