Unformatted text preview: x shields and cost of financial distress. 8.8 The Trade-off theory of capital structure
The trade-off theory states that the optimal capital structure is a trade-off between interest tax shields and
cost of financial distress:. Please click the advert Try this... Challenging? Not challenging? Try more www.alloptions.nl/life
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64 Corporate Finance Corporate ﬁnancing and valuation (47)
Value of firm = Value if all-equity financed + PV(tax shield) - PV(cost of financial distress)
The trade-off theory can be summarized graphically. The starting point is the value of the all-equity
financed firm illustrated by the black horizontal line in Figure 10. The present value of tax shields is then
added to form the red line. Note that PV(tax shield) initially increases as the firm borrows more, until
additional borrowing increases the probability of financial distress rapidly. In addition, the firm cannot be
sure to benefit from the full tax shield if it borrows excessively as it takes p...
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This note was uploaded on 10/26/2012 for the course 19 19 taught by Professor - during the Spring '12 term at Sunway University College.
- Spring '12