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Trade-off theory

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Real estate purchases are often financed with at least 80% debt. Most corporations however have less than 50% debt financing. Provide an explanation for this difference using the trade-off theory.

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The trade off model of the capital structure decisions says that a firm has to make a trade off between the benefits of debt and costs of debt. The benefit of tax is the tax shield and the cost of debt is the cost of financial distress. As interest on debt is a deductible expense for the purpose of tax calculations, increasing the level of debt would increase the amount of tax shield available. However, increasing the level of debt would increase the risk of financial distress, a situation when a firm is not able to meet its ...

Solution Summary

This post discusses the difference by using the trade-off theory between different percentage of debt financing.