Question

In the trade-off theory, debt levels chosen to balance interest tax shield against the costs of financial distress imply:________

a. an interior optimum (firm value maximizing) debt ratio
b. that investors are irrational, since they require lower returns the hgher the risk
c. that a firm would use little to no debt
d. that a firm would borrow as much as possible

Answer 1

a) an interior optimum (firm value maximizing) debt ratio

Step-by-step explanation:

Trade off Theory is about capital structure of an economic unit. It mentions about the benefit of debt - ie tax saving, as interest on debt is tax deductible; & cost of debt - bankruptcy & insolvency risk, due to fix interest cost.

The theory depicts the debt level, which is best to - balance interest tax shield against the costs of financial distress imply, which implies that it seeks a balance between benefit & cost of debt.

So, the theory finds the best interior optimum (firm value maximising) debt equity ratio.