Question

Based on the tradeoff theory of capital structure, at what point is the value of the firm maximized?

a) at a debt ratio of 100%

b) when the advantage of leverage is equal to the after-tax cost of debt

c) when the benefits of leverage is offset by higher interest rates and cost of financial distress

d) at a debt ratio of 0%

Answer 1

Capital structure decision is based on tradeoff theory. the tradeoff between level of risk and overall cost of capital/ there is two main part of capital structure that is debt and equity. the cost of debt is usually less and interest payment on debt capital is deductible from taxable income. So, if company use more debt than overall cost of capital of company reduced.

at the same time when company use more debt the probability of bankruptcy increase. so, the manager must tradeoff between bankruptcy risk and cost of capital while making decision about capital structure.

So, According to tradeoff theory of capital structure, value of the firm maximized when the benefits of leverage is offset by higher interest rates and cost of financial distress.

Option (C) is correct answer.