Trade-Off Theory Vs Capital Structure Theory

In corporate finance there exists a large body of literature that examines the financing behaviour of firms, reflected by their capital structure. There are two competing capital structure theories which are trade-off theory and pecking order theory. In these two capital structure theories, there are some differences.

First of all, the trade-off theory, which focuses on the benefits and costs of issuing debt, predicts that an optimal target financial debt ratio exists, which maximizes the value of the firm. The optimal point is achieved when the marginal value of the benefits associated with debt issues exactly offsets the increase in the present value of the costs associated with issuing more debt (Myers, 2001). The benefits of debt are

The trade-off theory implies a target-adjustment model (Taggart, 1977; Jalilvand and Harris, 1984; Ozkan, 2001). In this model firms have a target debt ratio to which they gradually adjust. The debt is adjusted by comparing the actual level or ratio of debt in the previous period with the predetermined target debt level or ratio. The adjustment, though, is only partial due to market imperfections such as transaction costs (Marsh, 1982), adjustment costs and constraints (Jalilvand and Harris, 1984). If firms are above the target debt ratio the value of the firm is not optimal because financial distress and agency costs exceed the benefits of debt. Therefore, we expect firms that are above their target debt ratio, to decrease their debt in the current period. Firms that have a debt ratio below the target debt ratio can still increase the value of the firm because marginal value of the benefits of debt are still greater than the costs associated with the use of debt. Therefore, we expect firms whose debt in the previous period was situated below the target level, to increase their debt. The cost and benefits of debt make that firms that are below the target debt ratio increase their debt and firms that are above the target debt ratio decrease their debt, although the speed of these adjustments could differ (Durinck, Laveren, Van Hulle and Vandenbroucke, 1998).

However, the pecking order theory developed by

Transaction costs associated with external finance play an important role in selecting financing sources. Firms will first use internal equity financing, followed by external debt financing and finally external equity financing. Debt financing precedes equity issues because transaction costs for debt are lower than for equity issues (Baskin, 1989). The reliance on internal finance can also be a by-product of the desire of managers to avoid external financing because it subjects them to the discipline of the market (Myers, 1984). Especially the owner-manager of the company does not like to lose control over the firm (Holmes and Kent, 1991; Hamilton and Fox, 1998). Therefore managers are very reluctant to accept new shareholders and will try to finance their activities as much as possible with internal funds. If the firm’s retained earnings do not suffice, management will choose the financing source without control restrictions. Therefore management will opt for short-term debt because no collateral is required and no covenants are imposed, followed by long-term debt and finally equity