Net agency costs of equity and Static trade-off capital structure theory

"In selecting a refinancing plan, we must not push our leverage ratio too high. An overly aggressive leverage ratio will likely cause debt rating agencies to downgrade our debt rating from its current rating, causing our cost of debt to rise dramatically."

• This effect is explained using the static trade-off capital structure theory, which states that if our debt usage becomes high enough, the marginal increase in the interest shield will be more than the marginal increase in the costs of financial distress.
• However, using some additional leverage will benefit the company by reducing the net agency costs of equity required to align the interests of the company's management with its shareholders.

Are these staments correct?

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Answer: Only correct with respect to the net agency cost of equity.


Static trade-off capital structure theory
A company should lever up to the point at which the additional increase in the costs of financial distress exceeds the additional increase in the tax shield from interest rate payments. Once this point is reached, adding more leverage to the company will decrease its value.

So, the correct statement should be "if our debt usage becomes high enough, the marginal increase in the interest shield will be less than the marginal increase in the costs of financial distress."


Net agency cost of equity
Agency costs include equity holders' cost to monitor the firm's executives, management's bonding costs to assure owners that their best interests are guiding the company's actions, and residual losses that result even when sufficient monitoring and bonding exists. Adding additional debt reduces the agency costs to equity holders because less of their capital is at risk. The leverage effectively shifts some agency costs to bondholders. Additionally, managers have less cash to squander when higher leverage is employed because higher interest costs will restrict discretionary free cash flow.