The trade-off theory of capital structure states that leverage is increased until the marginal cost of debt is equal to the marginal benefit.

Question

Quizplus · Accepted Answer

The trade-off theory of capital structure suggests that a company's optimal capital structure involves a balance between the tax benefits of debt and the costs and risks associated with borrowing. According to this theory, a company will continue to increase its leverage (or debt-to-equity ratio) until the marginal cost of adding more debt (e.g. higher interest payments, potential bankruptcy costs) equals the marginal benefit (e.g. tax deductions for interest payments, increased financial flexibility). Therefore, the statement "the trade-off theory of capital structure states that leverage is increased until the marginal cost of debt is equal to the marginal benefit" is correct.

The Trade-Off Theory of Capital Structure States That Leverage Is