The trade-off theory of capital structure recognizes the tax-shield benefit of debt financing, but also recognizes that the benefit may at some point be offset by costs associated with financial distress.

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The trade-off theory of capital structure acknowledges that debt financing provides tax-shield advantage, but excessive debt can lead to financial distress, which results in costs such as bankruptcy, legal fees, and restructuring costs. Therefore, the theory suggests a balance between the benefits and costs of debt financing.

The Trade-Off Theory of Capital Structure Recognizes the Tax-Shield Benefit