Which of the following is consistent with the trade-off theory of capital structure?
A)The cost of capital continuously decreases as the firm's debt ratio increases.
B)The cost of capital remains constant as the firm's debt ratio increases.
C)There are no costs associated with bankruptcy.
D)There is an optimal level of debt financing.

Question

Quizplus · Accepted Answer

The trade-off theory states that there is an optimal level of debt financing that balances the benefits of the tax shield with the costs of financial distress and agency costs. This suggests that at some point, increasing debt will cause the costs of financial distress to outweigh the tax benefits, resulting in a higher cost of capital. Therefore, option D is the most consistent with the trade-off theory of capital structure. Options A and B are incorrect because they suggest that the cost of capital continuously decreases or remains constant, which is not consistent with the trade-off theory. Option C is incorrect because there are significant costs associated with bankruptcy, including legal fees and lost reputation.

Which of the Following Is Consistent with the Trade-Off Theory