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IAI Actuarial Core Principles · Business Finance · Capital structure and dividend policy

Which of the following is the main reason the trade-off theory predicts a finite optimal level of gearing for a company?

The trade-off theory sets the tax benefit of interest deductibility against the growing expected costs of financial distress as gearing rises. The optimum is where the marginal tax gain equals the marginal distress cost, so gearing has a finite best level.

  1. ATax relief on interest is balanced against rising expected costs of financial distress at high gearingCorrect
  2. BDividends are paid out of post-tax profits while interest is not
  3. CShareholders prefer retained earnings to new issues of shares
  4. DDebt holders always demand a lower return than shareholders
  5. Managers have better information than outside investors about the firm's prospects

Explanation

Trade-off theory balances the tax advantage of debt against the expected costs of financial distress and bankruptcy, which rise with gearing. The optimum lies where the marginal benefit equals the marginal cost. Option 5 describes the pecking order theory, which gives no target gearing.

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