A theory that companies choose their capital structure by balancing the tax benefits of debt against the costs of financial distress. It suggests there's an optimal debt level where the marginal benefit equals the marginal cost.
From Middle English 'trade' (path/course) and 'off' (away). The financial theory developed in the 1960s-70s as economists sought to explain capital structure decisions following Modigliani-Miller's work on capital structure irrelevance.
The trade-off theory explains why most companies don't load up on debt despite tax benefits - bankruptcy costs, agency costs, and loss of financial flexibility eventually outweigh the tax shields. It's like eating dessert: a little is great, too much makes you sick!
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