1) According to the trade-off theory of capital structure,

1. optimal capital structure occurs when the present value of tax savings on account of additional borrowing just offsets the increase in the present value of costs of distress.
2. optimal capital structure occurs when the stockholders' right to default is balanced by the bondholders' right to get interest and principal payments.
3. optimal capital structure occurs when the benefits of limited liability is just offset by the value of the firm's lawyers' claims.
4. None of the options are correct.

2) What does "risk shifting" imply?

1. When faced with bankruptcy, managers tend to invest in high-risk, high-return projects.
2. When faced with bankruptcy, managers do not invest more equity capital.
3. When faced with bankruptcy, managers may make accounting changes to conceal the true extent of the problem.
4. When faced with bankruptcy, managers invest in low-risk projects to conserve capital.