Question

Trade-off theory suggests that the capital structure decision is essentially a cost- benefit analysis. What benefit and cost do firms compare when making financing decisions?

Answer 1

Cost benefit analysis is the process used to measure the benefits of the decision minus cost associated with taking the decision.

The Benefits taken into consideration in cost benefit analysis while making financing decision are :-

1)Revenue or sales from the project- Is there sufficient revenue generated to cover up the cost incurred in the project

2) Competitive advantage the firm will get from implementing the project

The Costs which are taken into consideration are as follows:-

1)Direct and indirect cost which is incurred in making the goods

2) Opportunity cost, of choosing another alternative, and

3) Last but not the least, cost of change in any rules or regulation which might affect the project such as environmental regulations.

These are the benefits and cost which are compared before making a financial decision. If the benefit is more than the cost then the project is taken and if benefit is less than the cost then the project is dropped.