The trade-off theory of capital structure predicts that
A)unprofitable firms should borrow more than profitable ones.
B)safe firms should borrow more than risky ones.
C)rapidly growing firms should borrow more than mature firms.
D)increasing leverage increases firm value, especially at high debt ratios.

Question

Quizplus · Accepted Answer

The trade-off theory of capital structure suggests that firms have to trade-off the benefits and costs of taking on debt financing. Safe firms with lower risk levels would benefit more from taking on debt than risky firms, as they are more likely to be able to make regular payments on the debt and avoid default. On the other hand, risky firms may have difficulty servicing their debt obligations and may cause their financial distress or bankruptcy. Therefore, the trade-off theory suggests that safe firms should borrow more than risky ones to reach their optimal level of debt.

The Trade-Off Theory of Capital Structure Predicts That