According to the trade-off theory of capital structure:
A) optimal capital structure is reached when the present value of tax savings on account of additional borrowing is just offset by increases in the present value of costs of distress.
B) optimal capital structure is reached when stockholders' right to default is balanced by the the bondholders' right to get interest and principal payments.
C) optimal capital structure is reached when the benefits of limited liability is just offset by the value of the lawyers' claim.
D) none of the above

Question

Quizplus · Accepted Answer

The trade-off theory of capital structure suggests that the optimal capital structure is achieved when the present value of tax savings on account of added borrowing is balanced by the present value of costs of financial distress. This means that companies should try to strike a balance between the tax benefits of debt financing and the increased risk of financial distress due to added debt. Therefore, option A is the correct choice. Option B is incorrect because it relates to the balance of rights between stockholders and bondholders, rather than the trade-off between debt and equity financing. Option C is also incorrect as it is not related to the trade-off theory of capital structure.

According to the Trade-Off Theory of Capital Structure