Trade-off Theory

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Trade-off Theory by Mind Map: Trade-off Theory

1. refer to the idea that chosen by a company to balancing the costs and benefits

1.1. how much debt finance

1.2. how much equity finance to use

2. deals with the two concepts

2.1. cost of financial distress

2.2. tax savings

3. companies or firms are generally financed by both equities and debts.

4. important purpose

4.1. to explain the fact that corporations usually are financed

4.1.1. partly with debt

4.1.2. partly with equity

5. cost of debt is usually the financial distress costs or bankruptcy costs of debt

5.1. includes the direct and indirect bankruptcy costs

5.2. include the agency costs from agency theory as a cost of debt

5.2.1. to explain why companies don’t have 100% debt

6. advantage to financing with debt

6.1. the tax benefits of debt

7. cost of financing with debt

7.1. the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs

7.1.1. e.g. staff leaving, suppliers demanding disadvantageous payment terms, etc

8. the marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases

8.1. firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing

9. a firm experiences financial distress when the firm is unable to cope with the debt holders’ obligations