Question

List the factors that might influence a firm’s choice of capital structure in the real life and explain how each factor affects the optimal leverage ratio in the context of tradeoff theory.

Answer 1

Factors that might affect a firm's choice of capital structure in the real life:
1. Cost of Debt
2. Cost of Equity
3. Tax Rate
4. Issuance cost and distress costs

Trade off theory explains the choice of debt and equity taking into consideration the costs and benefits involved.

1. Higher the cost of debt leverage should be decreased and more equity should be increased to obtain optimal capital structure. Similarly lower the cost of debt higher should be the leverage to obtain optimal capital structure./
2. Higher the cost of equity more debt should be issued and shares should be bought back and lower the cost of equity more shares should be issued to obtain optimal capital structure.
3. Higher the tax rate more is the benefit of the interest tax shield hence more debt should be issued to get optimal capital structure.
4. Issuance costs of equity is higher than debt and in case of higher debt distress costs also increase.By analysing the issuance costs and distress costs optimal debt equity ratio can be obtained.