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Trade-off Theory of capital structure balances:
AInventory and receivables
BSales and EBIT
CTax shield benefits and bankruptcy/financial-distress costs
DEquity and reserves
Answer & Solution
Correct answer: C. Tax shield benefits and bankruptcy/financial-distress costs
1. Trade-off Theory: optimal capital structure balances marginal tax-shield benefit of debt vs marginal financial-distress cost.
2. Predicts an interior optimum debt-equity ratio.
3. Extends MM-with-taxes by incorporating bankruptcy costs.
_Source: ICAI BoS CA Inter Paper 6A, Ch 5 "Financing Decisions — Capital Structure", §2 — Theories_