Discussion QuestionThe tradeoff theory assumes that in determining the capital structure, firms have the liberty to choose between the amount of debt capital and equity capital to employ. The firm can utilize debt capital and equity capital until the optimal balance is achieved. The theory explains why the majority of corporations have both debt capital and equity capital in their capital structures. According to the tradeoff theory, firms have an incentive to increase leverage in their capital structure. The incentive to adding leverage is accrued from the tax benefits of the debt interest payments made by the firm. The theory stipulates that there is an incentive in the financing of the debt because of the tax benefits ensued by the interest payments. However, the firm must be wary of the cost of financial distress that would result from the bankruptcy caused by the introduction of high debt capital. For this reason, it is significant for the firm to consider the present value (PV) of the tax shield accrued from increased leverage and the costs of financial distress.

The indirect costs of financial distress that derive from a firm’s inability to pay its creditors have various effects on the firm. First off, the firm may need to cut some of its investments such as market research, research and development, and other critical investments that are crucial to its market performance. The firm may also face opportunity costs, particularly when managers try to pass high-risk projects. The reputation of the firm is also affected by indirect costs of financial distress which may lead to a decline in sales coupled with high costs of capital.

Response
I agree with my classmate that the tradeoff theory is the idea that a firm chooses how much debt capital and how much equity capital to use by balancing the benefits and costs. It is also true that increasing the amount of debt increases the amount of risk to a company which somehow offsets the decline of the WACC. Regarding the indirect costs of financial distress, it is correct that highly levered firms in industries experiencing poor performance suffer large declines in sales and market value of equity as compared to their less unlevered competitors. As such, leverage presents real costs in times of economic distress.