Trade-Off Theory: How Firms Optimize Their Own Capital Structure
According to the trade-off theory, firms can optimize their own capital structure because they encounter a trade-off between the advantages and disadvantages of debt on firm's market value; rising leverage by increasing debt means that the firm can benefit from debt tax shields, which will increase its value (Modigliani and Miller’s (1963) Proposition I under corporate taxes). However, high leverage leads to higher (expected) direct and indirect costs of financial distress, thus, decreasing the firm’s market value. Direct costs include the legal and administrative costs of liquidation or reorganization. Indirect costs refer to the impaired ability to conduct business and to agency costs of debt that are specifically related to periods of high …show more content…
However, in practice, a firm may choose not to adjust its capital structure immediately to the target. This will be the case, when the firm faces high adjustment costs or the financial system is not able to provide the financial needs. Actual capital structure may be adjusted partially to the target capital structure using the following formula Shyam-sunder and Myers (1999): ALit – ALit-1 =ⱷ (TL*it – ALit-1 )
Where, (TL*it) is the target leverage ratio, (ALit ) is the actual leverage ratio .
(ALit –ALit-1) is the net change in leverage , ( TL*it –ALit-1 ) measure how far the actual leverage ratio deviates from the target leverage . ⱷ1 is the adjustment coefficient that measure the speed of target adjustment .In order for partial adjustment to exist , ⱷ1 should be between zero and one ( 01 implies an adjustment more than necessary (over – adjustment).
To investigate whether they have different adjustment rates, we first study the optimal capital structure (TL*it), which is equal to :
TL*it = ALit- ALit-1
Where, TL*it is the targeted leverage ratio, ALit is the leverage ratio for firm (i) at time (t) , ALit-a is the leverage ratio for firm (i) at time
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