Which of the following is consistent with the Tradeoff theory of capital structure?
A)The cost of capital continuously decreases as the firm's debt ratio increases.
B)The cost of capital remains constant as the firm's debt ratio increases.
C)The cost of capital continuously increases as the firm's debt ratio increases.
D)There is an optimal level of debt financing.
E)Capital structure does not affect a firm's cost of capital.

Question

Quizplus · Accepted Answer

The Tradeoff theory of capital structure suggests that there is an optimal level of debt financing where the cost of debt (including bankruptcy costs) is balanced against the benefits of debt (including tax shields). Thus, the cost of capital is expected to decrease up to this optimal level and then increase beyond it as the firm takes on too much debt. So, the correct choice is D.

Which of the Following Is Consistent with the Tradeoff Theory