According to the trade-off theory,optimal capital structure occurs when:
A) additional borrowing results in lower financial distress costs.
B) additional borrowing is offset by the interest tax shield.
C) the tax savings from additional leverage are offset by the increased costs of distress.
D) the present value of the tax shield exceeds the value of the all-equity-financed firm.

Question

Quizplus · Accepted Answer

The trade-off theory suggests that there is an optimal capital structure that balances the benefits and costs of debt financing. In particular, as a firm increases its level of debt, it enjoys the benefits of the interest tax shield, which lowers the net cost of borrowing. However, at some point, the costs of financial distress that come from having too much debt begin to outweigh these benefits. These costs include potential bankruptcy, agency costs, and the risk of financial distress to the firm's stakeholders.

Therefore, the optimal capital structure is the point at which the benefits of debt (tax shield) are offset by the costs of distress. In other words, when the present value of the tax shield is equal to the expected present value of the costs of distress, the firm has achieved its optimal capital structure. Hence, the best choice is C, the tax savings from additional leverage are offset by the increased costs of distress.

According to the Trade-Off Theory,optimal Capital Structure Occurs When