The tradeoff theory suggests:
A)the firm should choose a debt level where the tax savings from increasing leverage are just offset by the increased probability of incurring the costs of financial distress.
B)with higher costs of financial distress,it is optimal for the firm to choose higher leverage.
C)differences in the magnitude of financial distress costs and the volatility of cash flows cannot explain the differences in the use of leverage across industries.
D)there is no rational explanation for why firms choose debt levels that are too low to fully exploit the debt tax shield.
E)the firm should choose a debt level where the cost of debt is equal to the cost of equity.

Question

Quizplus · Accepted Answer

The tradeoff theory suggests that there is an optimal debt level where the tax benefits of debt are balanced against the costs of financial distress. This optimal level of debt is the point where the tax savings from increasing leverage are just offset by the increased probability of incurring the costs of financial distress. Therefore, choice A is the best choice.

The Tradeoff Theory Suggests