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Discuss the trade-off theory of capital structure, including the determination of an optimal debt level.

Discuss the trade-off theory of capital structure, including the determination of an optimal debt level.

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Answer #1

The trade-off theory states that the financial distress increases with an increase of debt in existing capital structure. Tax shield on interest cost debt increases the value of the firm and which offset by the amount of distress firm carries. This means there is trade-off in selecting one over other. Increasing debt increases prospective financial distress.

The below equation simply puts above theory in numeric values:

Firm value = Value of all-equity financed + PV[(tax shield) - (cost of financial distress)]

The firm value is gaining due to PV of tax shield and same time the PV of distress is also incorporate which would leave a marginal benefit for the firm at overall level.

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