 Plato theory says that the value of a levered firm is equal to the value of a unlevered firm plus the present value of tax savings from debt less the present value of financial distress cost. This means that leverage has both costs as well as benefits. This means also that the leverage is an incentive for the firm to raise the amount of debt in order to exploit tax savings of debt. But it is important to note that the increasing amount of debt can put a firm under the riskiness of default and the firm may need to incur certain financial distress costs. So what are the determining factors of financial distress cost? The first is the probability of financial distress for a firm's inability to meet its debt obligations. This means that this probability increases with the firm's liabilities relative to the amount of firm's assets and this probability of default also increases due to the volatility of the firm's cash flows and its assets value. Now the firms with stable, reliable cash flows can use a higher amount of debt and may have a very low probability of default. The second factor is the magnitude of the distress cost that depends upon its relative importance. For example, the knowledge-based firms with specialized human capital may incur higher costs of financial distress when due to the potential for loss for customers and the need to hire and retain their skilled and key persons. The third factor is the discount rate that is used for distress costs and this discount rate depends upon the firm's market risk. The present value of distress cost will be higher for the firm that have higher beta. So what is the optimum level of leverage under the presence of financial distress cost? We have seen that the value of a levered firm is equal to the value of unlevered firm plus the present value of financial distress, present value of tax shields and less the present value of financial distress cost. This means that the value of levered firm varies with the level of the amount of permanent debt the firm has in its capital structure and with no debt the value of the firm is simply equal to the value of unlevered firm and for low level debt the default risk remains at the lower level. Rising leverage means that the interest rate, the amount of interest payment will be also higher and resulting tax shield from that higher amount of interest payments will be more higher to the firm. Assuming there is no financial distress cost then the firm value would continue to increase until the interest expense goes beyond the earnings before and tax of the firm. This means that the tax shield will no more be available to that particular firm. Financial distress cost reduces the value of the levered firm because this reduction increases with the probability of default that increases with the level of the debt the firm has in its capital structure. The trade off theory allows a firm to increase leverage to that level where the value of this particular firm is maximized. This means that at that particular point the tax savings from increasing leverage are just offset by the increased probability of increasing the financial distress cost. This means that the trade off theory allows a firm to increase leverage to a point where the present value of the tax shield of using debt are equal to the present value of the cost of financial distress. On the screen we are seeing a graph and that graph shows that increase in debt can increase the tax benefit means tax shield until the interest expense goes beyond the firm's habit. This increase in debt also increases the probability of default and the present value of financial distress cost. We see that at optimal level of debt these two effects balance out each other and the levered value is then maximized and if the firm has higher financial distress cost then it is better for the firm to keep its debt at lower level. Now to determine the optimal debt level we have an example we see that there is a company Greenleaf that is going to add 35 million amount as debt in its capital structure. The firm sees that the tax shield benefits may be exploited at the tax rate of 15%. The higher debt may expose to the risk of the financial distress of the firm. The firm has expected certain estimates of its future cash flows at certain debt level that reaches from 0 to 35 million so we have certain level of debt and we have corresponding level of present values of interest tax shields similarly we have the corresponding values of present value of financial distress cost in line with the debt levels. Now if we compute to determine this net benefit of that debt we need to deduct the present value of financial distress cost from the present value of interest tax shield. Now for all level of debt we have the net benefit and we see that for the debt level of 20 million dollars we have the higher amount of net benefit that is 2.62 million. So this is the level of debt that can be determined as the optimal debt choice for the firm because at this level of debt the firm has highest net benefit which is 2.62 million so in this particular case the optimal debt choice a firm can go for is the use of 20 million dollar as debt in its capital structure.