Trade Off Theory Analysis

The trade-off theory came into existence after the propositions of Modigliani and Miller and it was proposed by Kraus and Litzenberger in 1973. During the 60s, the trade-off theory was commonly recognized as the static trade-off theory. It states that a company chooses the amount of debt and the amount of equity to use to finance its operations by balancing the benefits and the costs. Obviously, the main purpose of the trade-off theory is to explain the fact that firms are partly financed with debt and partly with equity. In order to optimize its overall value, a firm will concentrate on this trade-off while defining its capital structure. The trade-off theory was then proposed as a dynamic theory which stated that the company may deviate

However, one of the drawbacks of debt is the financial ditress cost, especially when the firm relies on large amounts of debt. In static trade-off theory, an optimal capital structure is generated through the agency costs of financial distress and the tax-deductibility of debt finance. Therefore, firms’ capital structures are optimal when they are determined by comparison of the costs against the benefits of the use of debt and equity. In the following, we will mention some important costs and benefits involved with the use of debt and equity. One major cost factor is the agency costs. These costs are generated from a conflict of interest arising between creditors, shareholders and managers owing to differing goals. The shareholders wish for managers to run the firm in a way that increases shareholder value, but managers may wish to grow the firm by maximizing their personal power and wealth that may not be in the best interests of shareholders. This cost is called agency cost of equity. Another cost is an agency cost of debt which is an economic concept on the costs incurred by an organization associated with problems such as conflicts of shareholders-creditors’ objectives and information asymmetry. Shareholders may influence the managers’ financial decisions by controlling the board of directors, creditors’ benefits may be damaged. Consequently, the costs of

They claim a model of dynamic optimal capital structure choice with considering the recapitalization costs. This implies the firms’ capital structures may not always coincide with their target leverage ratios. In other words, as time goes on, the firm allows its debt ratio to vary because of considering the costs and the benefits of the use of debt and equity. In a dynamic model, the correct financing decision typically depends on the financing margin that the firm predicts in the next period. Gradually, the capital structure will approach the optimal