Question

Discuss the trade-off theory of capital structure? How does the trade-off theory impact the value of the firm and the earnings per share?

Answer 1

The trade-off theory of capital structure states that there should be optimum distribution of debt and equity in the capital structure of the company so that company can balance the costs and benefits. It is a trade-off between interest tax shields and cost of financial distress –

Value of firm = Value if all-equity financed + PV (tax shield) - PV (cost of financial distress)

Now from the above equation; we can see the present value of tax shield and present value of cost of financial distress has a direct impact on the value of the firm and therefore the earnings per share. The firms have to find out optimum debt levels where the value of the firm is maximum.