Trade-off theory
Principles of Finance glossary · Cost of Capital & Capital Structure
Definition
The theory that optimal capital structure balances the tax benefits of debt against costs of financial distress.
Trade-off theory in plain English
When a company borrows money (takes on "debt"), there's a nice perk: the interest it pays is tax-deductible, so borrowing lowers its tax bill. But pile on too much debt and the company risks not being able to pay it back — "financial distress," which can mean scary, expensive trouble or even bankruptcy. Trade-off theory says the smartest amount of borrowing sits at the sweet spot where the tax savings from one more dollar of debt exactly balance the added danger of distress. It's like adding hot sauce: a little makes the meal better, but there's a point past which more just ruins it.
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