The "trade-off theory" of capital structure suggests that firms have an optimal level of debt.

Question

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The trade-off theory of capital structure suggests that firms have an optimal level of debt that balances the tax benefits of debt with the costs of financial distress. This optimal level of debt is the point at which the marginal tax benefits of debt are equal to the marginal costs of financial distress. Above this level, the costs of financial distress become too high and outweigh the tax benefits, while below this level, the tax benefits of debt are not being fully utilized. Therefore, the theory suggests that firms should aim to maintain an optimal level of debt in order to maximize their value.

The "Trade-Off Theory" of Capital Structure Suggests That Firms Have