 To determine the value of a levered firm, we need to deduct the present value of agency cost of debt and the present value of financial distress cost and We need to then add the present value of agency benefit of benefits of debt and the present value of interest tax fields to the Value of an unlevered firm. So this gives the value of a firm in the existence of the leverage Now, let's see how the cost and benefits of leverage can affect the value of a firm On the screen, we can see a graph that is showing net effect of the cost and benefit of leverage on the firm We see that at that level where there is no debt, the value of firm is VU That is the unlevered value of this particular firm and with leverage the firm starts benefiting from the interest tax shield which is basically the product of present value into tax rate and multiplied with the level of debt or the amount of debt The benefit also include improved incentives for the management like reduction in wasteful investments and perks on the owners of the firm But we see that at too high level of the debt, it reduces firm value as the tax benefit is lost due to the negative Abit or the earning before interest and tax where the interest expense exceeds the earning earning before interest and tax of the firm and therefore the financial distress cost and agency cost of the leverage So we see that at level of the static which is the optimal level of debt at that level of debt it balances the cost and benefits of the leverage the optimal level of debt The relative magnitude of the different cost and benefit of the debt vary with the firms on character Sticks, let's take an example of R&D based firm In that particular firm, there are high R&D cost and future growth chances And this type of firm maintains low level of debt Such firms tend to have low current free cash flows because it needs little debt for tax shield or such firm needs to control managerial spending Such type of firms have higher Amount of human capital. Therefore, there are larger financial distress costs These type of firms can increase the risk of business strategy using some riskier technology And these type of firms often need additional capital to fund new investments prospects So in in these particular type of firms the agency costs of debt are higher We have another example of low growth mature firms These type of firms with stable cash flows and tangible assets often carry higher amount of debt Such firms tend to have high free cash flows with good investment opportunities So these firms have higher tax yields and incentive benefits of the leverage policy And in these types of firms, low financial distress cost of leverage is due to the tangibility of the firm's assets Because these assets can be liquidated for closer to the fair value in the market What is debt level in practice or we can see The trade off theory guides affirm in choosing Its capital structure to that can maximize the value for its current shareholders Affirm may not choose an optimal capital structure as it May have more debt than the optimal level Because shareholder in that particular firm will find it costly reducing as the benefit will accrue to the firms creditors from the holders of the Or pocket of the equity holders. So managers in such firms also take investment decisions while safeguarding their on wasted interest What is management entrenchment? Managers seek to minimize leverage primarily to avoid debt to secure their own Jobs and if managers sacrifice too much firm value, the angry shareholders may try to replace them with the newer one or The shareholders may also sell the firm to an other acquirer Under this hypothesis the firm will leave a firm have leverage Less than the optimal level or the de-historic And then the firm will increase this lower level of leverage to words the optimal level Or the de-historic only in response to the takeover threat or the threat of shareholder's activism