A theory that centers on the assumption that the value of a levered firm equals the value of same firm without leverage (unlevered firm). It attempts to determine the optimal target value of financial capital structure of a company by finding the compromise, which corresponds to the minimal value of weighted average cost of capital (WACC), taking into account three factors that typically affect the optimal debt-equity mix:

1. corporate income taxes: the corporate income tax code favors companies that use leverage, and therefore adds value to companies which rely on debt in their capital structure.

2. bankruptcy costs: the probability of loss increases as a company becomes unable to honor its debt obligations. This subtracts value from companies with debt financing.

3. agency costs: the inability to align management actions with shareholders’ needs in a levered company negatively impacts its value.

Further development of compromise theory focuses on the choice of type of the capital strategy (aggressive, moderate, conservative). Depending on the agreement of owners and management to the acceptable level of risk, the point of compromise can deviate from the minimum value of the weighted average cost, which reflects the substantial effect of financial decisions of the company within the risk/ return trade-off. Modern compromise theory relies upon the acknowledgment of miltifactorial nature of financial capital structure.

This theory is also known as the dynamic tradeoff model.