Question

Discuss the trade-off theory of capital structure and how it impacts the value of the firm and the earnings per share

Answer 1

Trade off theory of the capital structure will be advocating that there should be a proper trade-off between benefits which are provided by the debt capital with the cost of financial distress because debt capital will always be providing with the benefit of interest tax deduction as interest which are payable on the debt capital are tax deductible in nature and hence these interest payments will be providing benefits to the company but there are also risk associated with the cost of financial distress associated with the debt capital and it will have to be properly assessed because there has to be a proper trading off between the benefit due to the debt capital and the cost associated with the financial distress in order to select an optimum capital structure for the company.

Optimum capital structure for the company will have the appropriate mix of equity capital and debt capital and debt capital will be selected after trading off between the benefit and the cost so it will help the company in maximizing the rate of return because the company will have the optimum capital structure.

when the company will be having the optimum capital structure with appropriate mix of debt capital and equity capital & it will have an additional advantage in maximizing its overall rate of return because it will be able to lower its overall cost of capital and it will be able to maximize his overall rate of return.it will hence increase the Earning per share by having an optimal capital structure