The trade-off theory of capital structure describes the optimal capital structure for any firm as being the level of debt that:
A) minimizes the financial distress costs.
B) maximizes the present value of the interest tax shield.
C) equates the present values of the incremental interest tax shield and the incremental financial distress costs.
D) maximizes the after-tax cash flows that are internally generated.

Question

Quizplus · Accepted Answer

The trade-off theory suggests that an optimal capital structure is achieved when the marginal benefit of debt (the interest tax shield) equals the marginal cost of debt (financial distress costs). Therefore, the optimal capital structure is the level of debt that balances the present value of the incremental interest tax shield and the incremental financial distress costs. Option A is too conservative, as it only focuses on minimizing financial distress costs, while option B ignores the potential risk of financial distress and only focuses on maximizing the interest tax shield. Option D is not directly related to the concept of trade-off theory.

The Trade-Off Theory of Capital Structure Describes the Optimal Capital