Which of the following is a reasonable conclusion from the Tradeoff theory of capital structure?
A) A high debt ratio will result in a maximum price of a firm's common stock.
B) A firm's common stock price will not be affected by the amount of debt a firm uses.
C) A low debt ratio will result in a maximum price for a firm's common stock.
D) Modest levels of debt have a more favorable impact on a firm's average cost of capital and stock price than no debt.

Question

Quizplus · Accepted Answer

The Tradeoff theory suggests that there is an optimal level of debt for a company, beyond which the cost of financial distress will outweigh the tax benefits of debt. Therefore, the optimal level would be a modest level of debt. This level of debt would result in a lower cost of capital, and potentially higher stock prices, compared to a scenario with no debt. It is not suggested that a high debt ratio will result in a maximum price for the firm's common stock. Therefore, option A is incorrect. The statement that a firm's common stock price will not be affected by the amount of debt a firm uses is incorrect, making option B incorrect. Option C is not supported by the theory, which suggests that a low debt ratio might mean a low cost of financial distress, but also that the tax benefits of debt may not be fully taken advantage of.

Which of the Following Is a Reasonable Conclusion from the Tradeoff