What concept does the trade-off theory in finance address?

The trade-off theory in finance primarily addresses the balance between the benefits of using debt and the costs associated with financial distress. This theory posits that firms seek to optimize their capital structure by weighing the advantages of debt financing—such as the tax shield benefits against the risks that come with high levels of debt, which can lead to financial distress or bankruptcy.

When a company takes on debt, it can improve its Return on Equity (ROE) due to the leverage effect; however, as debt levels rise, so do the potential costs, such as increased bankruptcy risk and the likelihood of facing financial distress. Therefore, the trade-off theory suggests that firms aim to find an optimal point where the marginal benefit of the tax shield on debt equals the marginal cost of the potential financial distress, thus optimizing their overall value.

This understanding is essential for investment management, as it influences decisions about capital structure and how businesses might finance their operations while managing risk effectively.