CA Inter P6 · Chapter 5 · Question 9 of 9
Trade-off theory explains the optimal capital structure as the point where:
Test yourself: pick an answer
Reveal answer & explanation
Correct answer: D) The marginal benefit of the interest tax shield equals the marginal expected cost of financial distress
Explanation
Trade-off theory accepts that debt adds value through the interest tax shield. As borrowing rises, so do the expected costs of financial distress and bankruptcy. The optimal level of debt balances the marginal tax benefit against these marginal costs.
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