The Trade-off theory of capital structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits . Trade-off theory of capital structure basically entails offsetting the costs of debt against the benefits of debt.
The Trade-off theory of capital structure discusses the various corporate finance choices that a corporation experiences. The theory is an important one while studying the Financial Economics concepts. The theory describes that the companies or firms are generally financed by both equities and debts.
Trade-off theory of capital structure primarily deals with the two concepts – cost of financial distress and agency costs. An important purpose of the trade-off theory of capital structure is to explain the fact that corporations usually are financed partly with debt 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 of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.
Modigliani and Miller in 1963 introduced the tax benefit of debt. Later work led to an optimal capital structure which is given by the trade off theory. According to Modigliani and Miller, the attractiveness of debt decreases with the personal tax on the interest income. A firm experiences financial distress when the firm is unable to cope with the debt holders’ obligations. If the firm continues to fail in making payments to the debt holders, the firm can even be insolvent. The first element of Trade-off theory of capital structure, considered as the cost of debt is usually the financial distress costs or bankruptcy costs of debt. It is important to note that this includes the direct and indirect bankruptcy costs.
Trade-off theory of capital structure can also include the agency costs from agency theory as a cost of debt to explain why companies don’t have 100% debt as expected from Modigliani and Miller. 95% of empirical papers in this area of study look at the conflict between managers and shareholders. The others look at conflicts between debt holders and shareholders. Both are equally important to explain how the agency theory is related to the Trade-off theory of capital structure.
The direct cost of financial distress refers to the cost of insolvency of a company. Once the proceedings of insolvency starts, the assets of the firm may be needed to be sold at distress price, which is generally much lower than the current values of the assets. A huge amount of administrative and legal costs are also associated with the insolvency. Even if the company is not insolvent, the financial distress of the company may include a number of indirect costs like – cost of employees, cost of customers, cost of suppliers, cost of investors, cost of managers and cost of shareholders.
The firms may often experience a dispute of interests among the management of the firm, debt holders and shareholders. These disputes generally give birth to agency problems that in turn give rise to the agency costs. The agency costs may affect the capital structure of a firm. There may be two types of conflicts – shareholders-managers conflict and shareholders-debt-holders conflict. The introduction of a dynamic Trade-off theory of capital structure makes the predictions of this theory a lot more accurate and reflective of that in practice.