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CS Professional · Strategic Management and Corporate Finance · Sources of Corporate Funding

Which approach to capital structure holds that a firm should use debt up to the point where the tax shield benefit is balanced against the expected costs of financial distress?

Trade-off theory is the answer. It says a firm should add debt until the marginal tax shield from interest equals the marginal expected cost of financial distress, which gives an optimal capital structure. Other theories either favour unlimited debt, treat structure as irrelevant, or rank funding sources.

  1. ANet income approach
  2. BTrade-off theoryCorrect
  3. CNet operating income approach
  4. DPecking order theory

Explanation

Trade-off theory balances the tax advantage of interest against bankruptcy and distress costs, giving an optimal debt level. The net income approach says more debt always lowers cost, and the net operating income approach says structure is irrelevant. Pecking order theory ranks funding sources by preference (internal funds, then debt, then equity) and has no target ratio.

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