Question

Regarding the trade-off theory, a firm would reach its optimal capital structure if:

a. the tax savings from additional leverage are offset by the increased costs of distress.
b. the present value of the tax shield exceeds the value of the all-equity-financed firm.
c. additional borrowing results in lower financial distress costs.
d. additional borrowing is offset by the interest tax shield.

Answer 1

The answer is option C) additional borrowing results in lower financial distress costs.

Step-by-step explanation:

The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits.

Kraus and Litzenberger propounded the classical trade-off theory of capital structure. Here, it is considered a balance between the dead-weight costs of bankruptcy and the tax saving benefits of debt. Often agency costs are also included in the balance.

Therefore, a firm is said to have reached its optimal capital structure if it responds positively to additional borrowing.

Answer 2

The Correct Answer is C.

the trade-off theory posits that a firm would reach it's optimal capital structure if the tax savings from additional borrowing results in lower financial distress costs.

Step-by-step explanation:

The combination of debt and equity used by a company to finance its operations and growth is referred to as it's capital structure. Debt comes in the form of bond issues or loans, while equity may come in the form of common stock, preferred stock, or retained earnings.

A company capital structure is affected by cost of capital. The higher the cost of borrowing the less the present value of the firm’s future cash flows, discounted by the Weighted Average Cost of Capital (WACC) and vice versa.

The weighted average cost of capital (WACC) is arrived at by calculating a firm's cost of capital in which each category of capital and proportionately weighing them. Categories of capital include including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation.

Thus, the primary objective of the office of the finance manager should be to find the optimal capital structure that will result in the lowest WACC and the maximum value of the company (shareholder wealth).

Why?

The optimal capital structure is estimated by calculating the mix of debt and equity that minimizes the weighted average cost of capital (WACC) of a company while maximizing its market value.

Thus when additional borrowing results in lower financial distress costs, the firm achieves the potential to reach it's Optimal Capital Structure.

Cheers!