Question

1. According to the trade-off theory of capital structure:

1. An optimal capital structure is reached when stockholders' right to default is balanced by the bondholders' right to get interest and principal payments.
2. Optimal capital structure is reached when the benefits of limited liability is just offset by the value of the lawyers' claim.
3. An optimal capital structure is obtained by minimizing the WACC.

D. None of the above

Answer 1

Option C is correct. An optimal capital structure is obtained by minimizing the WACC.

Trade off Theory states that such capital structure is to be maintained that will minimise the Cost. i.e. How much Equity to be used or how much Debt to be used to form a capital structure that will minimise the Cost. i.e. WACC.

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