What are the theories that explain what a firm's capital structure should be and why do capital structures differ and how are they used to determine the classification in which a product fits? According to the trade-off theory, firms face a trade off when using debt financing - tax deductions of interest payments make debt an attractive form of financing, but using more debt increases a firm's chance of bankruptcy. Thus, the blue curve shows firm value as a function of the debt level. Moreover, as the graph suggest an optimal debt policy exists which maximized firm value. Figure 10, Trade-off theory of capital structure. In summary, the trade-off theory states that capital structure is based on a trade-off between tax savings and distress costs of debt. The trade-off theory suggests maintaining a capital structure that relies on taking advantage of the tax benefits of debt. Capital structure refers to the way in which a company finances operations through outside investment, and incorporates equity, bonds and other securities.