What does the Trade-Off Theory explain?
Understand the Problem
The question is asking about the explanation provided by the Trade-Off Theory in finance. It requires an understanding of how different financing methods relate to each other and the balancing of benefits and costs associated with using debt.
Answer
The Trade-Off Theory balances debt's tax benefits with financial distress costs to find optimal capital structure.
The Trade-Off Theory explains the balance a firm seeks between the benefits of debt, such as tax shields, and the costs of financial distress. It posits that firms aim to find an optimal capital structure by considering both debt and equity financing.
Answer for screen readers
The Trade-Off Theory explains the balance a firm seeks between the benefits of debt, such as tax shields, and the costs of financial distress. It posits that firms aim to find an optimal capital structure by considering both debt and equity financing.
More Information
The Trade-Off Theory is important in corporate finance as it helps businesses determine the best way to structure their debt and equity to maximize firm value.
Tips
A common mistake is neglecting the impact of financial distress cost, which can counteract the benefits gained from debt-related tax shields.
Sources
- Trade-Off Theory of Capital Structure | Definition + Factors - wallstreetprep.com
- Trade-off theory of capital structure - Wikipedia - en.wikipedia.org
- Trade-Off Theory - (Advanced Corporate Finance) - Fiveable - fiveable.me
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