trade-off theory states that the capital structure decision involves a tradeoff between the costs and benefits of debt financing.

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Trade-off theory suggests that a company must find a balance between the advantages and disadvantages of debt financing. The advantages of using debt financing include the tax deductibility of interest payments, the ability to benefit from a higher return on equity with borrowed funds, and increased financial leverage. However, the disadvantages of taking on too much debt include higher interest payments, the possibility of default, and the constraints that lenders may impose on the business.

Trade-Off Theory States That the Capital Structure Decision Involves a Tradeoff