Trade-Off Theory of Capital Structure | CFA Level 1 Exam Preparation

Trade-Off Theory of Capital Structure

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Question

The trade-off theory of capital structure implies that:

Answers

A. firms issue debt up to the level where the total value added by the debt tax shield is offset by expected bankruptcy costs.

B. firms will use debt up to the level where the flotation cost of new debt equals that of issuing more equity, thus minimizing the costs of raising capital.

C. managers are uncomfortable with either too much debt or too much equity and hence, tend to choose debt ratios around 0.40 to 0.60.

D. none of these answers.

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Explanations

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A. B. C. D.

According to the trade-off theory of capital structure, firms issue debt up to the level where the additional value added by the debt tax shield for another dollar of capital raised is offset by expected bankruptcy costs. This ensures that with only these two effects, the firm's stock price is maximized. Clearly, at this point, the total value added by the debt tax shield exceeds the expected bankruptcy costs.

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