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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 Download free ebooks at 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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