The trade-off 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)there is no rational explanation for why firms choose debt levels that are too low to fully exploit the debt tax shield.
D)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.

Question

Quizplus · Accepted Answer

The trade-off theory suggests that there is an optimal level of debt where the tax benefits of debt are balanced with the costs of financial distress. This point is known as the trade-off point. At this point, the benefits of debt are just offset by the costs of financial distress. Beyond this point, the costs of financial distress outweigh the benefits of debt. Therefore, the firm should choose the debt level where the tax savings from increasing leverage are just offset by the increased probability of incurring the costs of financial distress.

The Trade-Off Theory Suggests