Question

The trade-off theory suggests that: I. Holding other things constant, firms respond to a decrease in tax rate by issuing more debt II. Holding other things constant, firms respond to a decrease in tax rate by issuing less debt III. Firms issue debt only when they have investment opportunities that they cannot finance with internal sources

a. I b. II c. I, III d. II, III

Answer 1

Let's analyze all statements:

I - Incorrect because decreasing tax rate shall lead to a decrease in tax shield due to tax. This shall lead to the issuance of lesser debt.

II - Correct because decreasing tax rate shall lead to a decrease in tax shield due to tax. This shall lead to the issuance of lesser debt.

III-Correct because first, the firms would try to utilize internal earnings and then only would they opt for external finance.

Hence the correct option is d.