Apply trade-off theory to balance debt tax benefits against distress costs.
Do not stop at the tax shield. Price the shadow. The visible benefit Trade-off theory starts with a clear benefit: deductible interest can lower taxable income for profitable firms. Debt can also discipline capital allocation by making excess cash harder to waste. The hidden cost Distress does not begin at bankruptcy court. It begins when lenders tighten terms, suppliers shorten credit, customers hesitate, employees worry, and managers pass on good investments because cash must protect the balance sheet. The marginal test Average debt cost is not enough. The question is whether the next dollar of debt adds more value than…
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