Financial management Essay Example | Topics and Well Written Essays - 3000 words - 2

Financial management - Essay Example The theory acknowledges the use of both equity and debt financing of the firm operations. It holds that each firm has an optimal capital structure at which it maximizes the value of the firm, which is the point when the attractiveness of each additional debt unit declines, upon balancing its costs and benefits it brings to the firm (Ghazouani, 2013). By this the theory links a firm’s financial leverage to its profitability and optimum debt ratio. Proponents of the theory argue that debt financing can enable firms to achieve maximum profitability and value by making a trade off of the accrued benefits and cost. Financing firms with debt has the advantages of corporate tax benefits of the debt, but also suffer risks from bankruptcy and agency costs, which create financial distress for the firm. Tax shields are firm specific factors that influence firms financing decisions. Firms may choose to take additional debt with increases to tax shield offered. According to Chen, â€Å"the trade-off theory predicts that firms will increase their debt level to capture fully tax benefits until the expected marginal benefits are equal to the expected marginal costs of debt† (2012, p. 1). The higher the tax rate the greater the firm’s leverage and effectively a higher enterprise value. By maximizing the use of debt, firms on the other hand become more prone to losses due to increasing risks of bankruptcy. The firm’s over-borrowing could result to failure of paying the principle, chances of defaulting, and in the event of financial distress are unable to get extended credits from financial institutions, failure to pay dividends or attractive for investment (Kim, Heshmati and Aoun, n.d.). In turn they affect the firm’s profitability, performances and its value. Holding other variables constant, a point comes when a further debt increment becomes inversely and directly proportional to its marginal profits and costs,