What best captures the trade-off between debt and equity financing?

• A. Equity avoids fixed payments but dilutes ownership.
• B. Debt provides tax advantages and potential leverage but increases bankruptcy risk.
• C. There is no trade-off between debt and equity financing.
• D. Debt provides tax advantages and potential leverage but increases bankruptcy risk; equity avoids fixed payments but dilutes ownership.

Answer: (D)

The financing decision is a balance between benefits and risks of debt versus equity. Debt brings a tax shield because interest is tax-deductible, and it enables leverage, which can boost returns when things go well. But it also creates fixed payments and increases the risk of financial distress or bankruptcy if cash flows decline. Equity, by contrast, avoids fixed payments, giving more flexibility with cash flow, but it dilutes ownership and control and can be more costly to the firm due to the required return demanded by investors. The statement that combines both aspects—debt offering tax advantages and potential leverage while raising bankruptcy risk, and equity avoiding fixed payments but diluting ownership—best captures this trade-off.