According to the trade-off theory of capital structure,
A)optimal capital structure occurs when the present value of tax savings on account of additional borrowing just offsets the increase in the present value of costs of distress.
B)optimal capital structure occurs when the stockholders' right to default is balanced by the bondholders' right to get interest and principal payments.
C)optimal capital structure occurs when the benefits of limited liability is just offset by the value of the firm's lawyers' claims.
D)None of these options are correct.

Question

Quizplus · Accepted Answer

The trade-off theory of capital structure suggests that there is an optimal point of debt usage by considering the tax benefits of debt and costs of financial distress. It proposes that the optimal capital structure occurs when the present value of tax savings on account of additional borrowing is equal to the increase in the present value of costs of distress. Therefore, option A is correct, and options B and C are irrelevant to the trade-off theory. Option D is incorrect as one option is correct.

According to the Trade-Off Theory of Capital Structure