Trade-off theory
Trade-off theory holds that a firm's optimal debt level balances the tax-shield benefit of debt against expected financial distress costs. Value peaks where the marginal benefit of more debt equals its marginal cost.
FrameworkCapital structure theory
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Debt creates value through its interest tax shield, but higher leverage raises the odds of financial distress. Trade-off theory says firms should keep borrowing only until the present value of the tax shield benefit exactly equals the present value of expected distress costs — the point where firm value peaks.
Where it fits
SubjectCorporate FinanceAdvancedTopicCapital Structure & LeverageAdvanced
Check yourself
PracticeCORE
According to the trade-off theory of capital structure, which type of firm would most plausibly carry the highest debt-to-equity ratio?
Select an answer to check your understanding.