The Tradeoff Theory suggests that . A. with higher costs of financial distress, it is optimal for a firm to choose higher leverage B. there is no rational explanation for why firms choose debt levels that are too low to fully exploit the debt tax shield C. differences in the magnitude of financial distress costs and the volatility of cash flows cannot explain the differences in the use of leverage across industries D. a firm should choose a debt level where the tax savings from increasing leverage are just offset by the increased probability of incurring the costs of financial distress

The correct answer is D. The Tradeoff Theory suggests that a firm should choose a debt level where the tax savings from increasing leverage are just offset by the increased probability of incurring the costs of financial distress.

Explanation:

The trade-off theory of capital structure states that companies choose their leverage ratio to maximize benefits and minimize costs. The classic version of the hypothesis goes back to Kraus and Litzenberg, who observed a balance between the risk of loss of welfare from impending bankruptcy and the tax benefits of outside capital. In the trade-off theory, debt and equity financing are calculated in such a way that the present value of the tax shield is as large as possible and the present value of the costs of “financial distress” is possibly small.

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