Trade-off theory

Definition

Trade-off theory suggests that firms seek to balance the benefits of debt, such as tax shields, against the costs, including financial distress and bankruptcy risk. This results in an optimal capital structure where the marginal benefit of debt equals its marginal cost.

5 Must Know Facts For Your Next Test

1. Trade-off theory helps explain how firms determine their optimal capital structure.
2. Tax shields are a key benefit of taking on debt according to trade-off theory.
3. Financial distress and bankruptcy risks are primary costs considered in trade-off theory.
4. The theory suggests there is an optimal level of debt that maximizes firm value.
5. Trade-off theory contrasts with pecking order theory which does not prescribe an optimal capital structure.

Review Questions

• What are the key benefits and costs considered in trade-off theory?
• How does trade-off theory define the optimal capital structure for a firm?
• What distinguishes trade-off theory from pecking order theory?

Related terms

Optimal Capital Structure: The mix of debt and equity financing that minimizes a firm's cost of capital and maximizes its value.

Tax Shield: A reduction in taxable income resulting from allowable deductions such as interest on debt.

Financial Distress: A situation where a firm is struggling to meet its financial obligations, potentially leading to bankruptcy.