Background: The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger[1] who considered a balance between the dead-weight costs of bankruptcy and the tax saving benefits of debt. Often agency costs are also included in the balance. This theory is often set up as a competitor theory to the pecking order theory of capital structure. A review of the literature is provided by Frank and Goyal.[2]

An important purpose of the theory is to explain the fact that corporations usually are financed partly with debt and partly with equity. It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder infighting, etc.). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.

Situation: Company X stopped taking on more debt, and decided to file for bankruptcy, while company Y, kept benefiting from the tax benefits of debt, having a lower debt level.

Question: Which company fired more people, company X or company Y?
Answer: company X

Situation: Company X stopped taking on more debt, and decided to file for bankruptcy, while company Y, kept benefiting from the tax benefits of debt, having a lower debt level.

Question: Which company fired fewer people, company X or company Y?
Answer: company Y

Situation: Company X stopped taking on more debt, and decided to file for bankruptcy, while company Y, kept benefiting from the tax benefits of debt, having a lower debt level.

Question: Which company had more problems with stockholders fighting, company X or company Y?
Answer: company X

Situation: Company X stopped taking on more debt, and decided to file for bankruptcy, while company Y, kept benefiting from the tax benefits of debt, having a lower debt level.

Question: Which company had less problems with stockholders fighting, company X or company Y?
Answer: company Y

Situation: Company X stopped taking on more debt, and decided to file for bankruptcy, while company Y, kept benefiting from the tax benefits of debt, having a lower debt level.

Question: Which company had more costs than benefits related to debt, company X or company Y?
Answer: company X

Situation: Company X stopped taking on more debt, and decided to file for bankruptcy, while company Y, kept benefiting from the tax benefits of debt, having a lower debt level.

Question: Which company had fewer costs than benefits related to debt, company X or company Y?
Answer: company Y

Situation: Company X stopped taking on more debt, and decided to file for bankruptcy, while company Y, kept benefiting from the tax benefits of debt, having a lower debt level.

Question: Which company had more disadvantageous payment terms, company X or company Y?
Answer: company X

Situation: Company X stopped taking on more debt, and decided to file for bankruptcy, while company Y, kept benefiting from the tax benefits of debt, having a lower debt level.

Question: Which company had less disadvantageous payment terms, company X or company Y?
Answer: company Y

Situation: Company X stopped taking on more debt, and decided to file for bankruptcy, while company Y, kept benefiting from the tax benefits of debt, having a lower debt level.

Question: Which company discharged more debt, company X or company Y?
Answer: company X

Situation: Company X stopped taking on more debt, and decided to file for bankruptcy, while company Y, kept benefiting from the tax benefits of debt, having a lower debt level.

Question: Which company discharged less debt, company X or company Y?
Answer: company Y