Trade Off Theory
This theory proposes to increase debt levels to balance interest to shield against the cost of financial distress. The company should keep on borrowing until the marginal tax advantage of additional debt is offset by the increase in present value of the expected costs of financial distress.
Pecking Order
Companies with higher earnings should take less debt, as they require less of funding requirements due to funding met by the internal resources. A high profit making company can generate internal cash to fund their new projects.
A balance between risk and return met by capital structure is known as the most favorable capital structure. A sound capital structure aims at minimizing the risk and maximizing the profit margins. It maximizes the price of the stock and minimizes the cost of capital at the same time.