Trade-off Theory

Trade-off Theory explains how companies decide the optimal amount of debt to carry. Borrowing (debt) can help finance growth and provide tax benefits, but too much increases the risk of financial problems or bankruptcy. Conversely, using too little debt might miss out on potential growth advantages. Firms balance these factors—costs of debt versus benefits—to find a sweet spot that maximizes value. Essentially, they weigh the benefits of debt against the risks, aiming for an optimal level that enhances overall financial health and shareholder value.