The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger who considered a balance between the dead-weight costs of bankruptcy and the tax saving benefits of debt. Often agency costs are also included in the balance. This theory is often set up as a competitor theory to the pecking order theory of capital structure. A review of the trade-off theory and its supporting evidence is provided by Ai, Frank, and Sanati. An important purpose of the theory is to explain the fact that corporations usually are financed partly with

debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The ...

and partly with equity. It states that there is an advantage to financing with debt, the

tax benefits of debt In the context of corporate finance, the tax benefits of debt or tax advantage of debt refers to the fact that from a tax perspective it is cheaper for firms and investors to finance with debt than with equity. Under a majority of taxation systems ...

and there is a cost of financing with debt, the costs of financial distress including

bankruptcy costs of debt Within the theory of corporate finance, bankruptcy costs of debt are the increased costs of financing with debt instead of equity that result from a higher probability of bankruptcy. The fact that bankruptcy is generally a costly process in itsel ...

and non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder infighting, etc.). The

marginal benefit In economics, utility is the satisfaction or benefit derived by consuming a product. The marginal utility of a good or service describes how much pleasure or satisfaction is gained by consumers as a result of the increase or decrease in consump ...

of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is

optimizing Mathematical optimization (alternatively spelled ''optimisation'') or mathematical programming is the selection of a best element, with regard to some criterion, from some set of available alternatives. It is generally divided into two subfi ...

its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.

Evidence

The empirical relevance of the trade-off theory has often been questioned.

Miller A miller is a person who operates a mill, a machine to grind a grain (for example corn or wheat) to make flour. Milling is among the oldest of human occupations. "Miller", "Milne" and other variants are common surnames, as are their equivalent ...

for example compared this balancing as akin to the balance between horse and rabbit content in a stew of one horse and one rabbit. Taxes are large and they are sure, while bankruptcy is rare and, according to Miller, it has low dead-weight costs. Accordingly, he suggested that if the trade-off theory were true, then firms ought to have much higher debt levels than we observe in reality.

Myers Myers as a surname has several possible origins, e.g. Old French ("physician"), Old English ("mayor"), and Old Norse ("marsh"). People * Abram F. Myers (born 1889), chair of the Federal Trade Commission and later general counsel and board ch ...

was a particularly fierce critic in his Presidential address to the American Finance Association meetings in which he proposed what he called "the pecking order theory".

Fama FAMA () is a Hong Kong hip hop duo consisting of members C Kwan and Luk Wing (6-Wing). Formed in 2002, the duo have since released 10 studio albums and EPs. Known for their quick-wit and humour, along with the use of lyrics and music to reflect ...

and French criticized both the trade-off theory and the pecking order theory in different ways. Welch has argued that firms do not undo the impact of stock price shocks as they should under the basic trade-off theory and so the mechanical change in

asset prices In finance, valuation is the process of determining the present value (PV) of an asset. In a business context, it is often the hypothetical price that a third party would pay for a given asset. Valuations can be done on assets (for example, inve ...

that makes up for most of the variation in capital structure. Despite such criticisms, the trade-off theory remains the dominant theory of corporate capital structure as taught in the main corporate finance textbooks. Dynamic versions of the model generally seem to offer enough flexibility in matching the data so, contrary to Miller's verbal argument, dynamic trade-off models are very hard to reject empirically.

References

{{DEFAULTSORT:Trade-off theory of capital structure Corporate finance Debt Finance theories no:Hakkeordensteorien

Evidence

See also

References