Unformatted text preview: ositive earnings to save
corporate taxes. Cost of financial distress is assumed to increase with the debt level.
The cost of financial distress is illustrated in the diagram as the difference between the red and blue curve.
Thus, the blue curve shows firm value as a function of the debt level. Moreover, as the graph suggest an
optimal debt policy exists which maximized firm value.
Figure 10, Trade-off theory of capital structure
value of firm Costs of
financial distress PV of interest
tax shields Value of
firm Optimal debt level Debt
level In summary, the trade-off theory states that capital structure is based on a trade-off between tax savings
and distress costs of debt. Firms with safe, tangible assets and plenty of taxable income to shield should
have high target debt ratios. The theory is capable of explaining why capital structures differ between
industries, whereas it cannot explain why profitable companies within the industry have lower debt ratios
(trade-off theory predicts the oppo...
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