Question

1) What is Trade-off theory?

2) Discuss the nature of Hang Seng Bank’s business and the costs and benefits of using debt based on the predictions of the trade-off theory.

3) Hang Seng Bank’s debt usage is consistent with the predictions of the trade-off theory?

4) Hang Seng Bank’s debt usage is consistent with the predictions of the pecking order theory?

Answer 1

1.Trade off theory of capital structure focuses at maintaining optimal mix of capital structure which focuses on adequate proportion of debt financing and equity financing.

Trade off theory states that optimal mix is an trade off between interest tax shield and the cost of financial distress.it States that optimal mix of capital is tradeoff between the tax savings and distressed cost of debt.

This theory emphasizes that a firm which have a high return on capital can utilise a high debt to its overall proportion of capital, because it's return on capital would be adequate enough to beat the cost of debt, and it can also help in generation of a lot of tax savings.it emphasizes on creating value for the firm through a trade-off between tax savings and the cost of distress incorporated into the debt.