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) There are no costs associated with bankruptcy.
D) There is an optimal level of debt financing.

Question

Quizplus · Accepted Answer

The Tradeoff theory of capital structure proposes that there is an optimal level of debt financing for a firm, where the tax advantages of debt are balanced against the costs of financial distress and bankruptcy. Therefore, only option D is consistent with this theory. Option A and B are inconsistent because the cost of capital may increase as the firm's debt ratio increases due to the increased risk of financial distress. Option C is also inconsistent because there are significant costs associated with bankruptcy, such as legal fees, lost sales, and damage to the firm's reputation.

Which of the Following Is Consistent with the Tradeoff Theory