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Identify the major tradeoffs between taking on a large load of debt due to its lower...

Identify the major tradeoffs between taking on a large load of debt due to its lower cost versus the increased probability of financial distress when too much debt is used on the other hand. How does this relate to an optimal capital structure?

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Answer #1

If a firm takes up more debt, the tax shield (Debt interest expense * tax rate) helps reduce tax outgo and thereby increases profit after tax. So there is an advantage in raising debt levels.

On the other hand, as debt levels rise, periodic interest payments to be made to creditors raises. In an economic downturn or even in an industry specific downturn, the demand for the firm's products may drop. Servicing of interest expense then may become untenable. So bankruptcy may become a possibility.

An optimal capital structure is one that takes into account the balancing of the trade off mentioned above and provides sustainable tax shield.

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