According to the trade-off theory, how is the capital structure determined? Firms have an incentive to add leverage to the capital structure. Briefly describe an incentive to add leverage. Then, refer to Equation 16.10 (attached PDF) in the material this week and explain how indirect costs of financial distress affect firms in different ways.
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Part 2: Respond to classmate below:
“Capitals structure is portrayed as degree of commitment and incentive in its bookkeeping report. Capital structure stress with simply whole deal commitment and incentive in capital. The company sets target capital structure at which general cost of capital is slightest. This capital structure is in like manner called perfect capital structure.
The tradeoff theory expect that there are favorable circumstances to use inside a capital structure up until the point that the perfect capital structure is come to. The theory sees the assessment decrease from interest portions. Studies suggest, regardless, that most companies have less use than this theory would propose is perfect.
At the time when company incorporate all the more simplicity commitment the levered beta additions in this way cost of significant worth is in like manner increases. Nevertheless, due to tax cut on the commitment the general cost of capital decreases.”