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 An agency cost is an economic concept that refers to the costs associated with the relationship between a " principal" (an organization, person or group of persons), and an " agent". The agent is given powers to make decisions on behalf of the prin ...

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 Loan, borrowed or otherwise withheld from another party, the creditor. Debt may be owed by a sovereign state or country, local government, company, or an individual. Co ...

and partly with equity. It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder infighting, etc.). The

marginal benefit Marginal utility, in mainstream economics, describes the change in ''utility'' (pleasure or satisfaction resulting from the consumption) of one unit of a good or service. Marginal utility can be positive, negative, or zero. Negative marginal utilit ...

of further increases in debt declines as debt increases, while the

marginal cost In economics, the marginal cost is the change in the total cost that arises when the quantity produced is increased, i.e. the cost of producing additional quantity. In some contexts, it refers to an increment of one unit of output, and in others it ...

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 criteria, from some set of available alternatives. It is generally divided into two subfiel ...

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 equivalents ...

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 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 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 that makes up for most of the variation in

capital structure In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders' equity, debt (borrowed funds), and preferred stock, and is detailed in the ...

. 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