Trade Off Theory Case Study

957 Words4 Pages
2.2 Trade-off Theory According to Murray and Vidhan (2007), trade-off theory is a solution to balance marginal costs and marginal benefits. From their survey, there are two definition to explain this theory. Firstly, a firm is said to establish the static trade-off theory if the firm’s leverage is determined by a single period trade-off between the tax benefits of debt and the deadweight costs of bankruptcy. Second, a firm is said to exhibit target adjustment behavior if the firm has a target level of leverage and if deviations from that target are gradually removed over time. The trade-off theory of capital structure explained the idea that a company decides on the amount of debt finance and how much equity finance to use by balancing the…show more content…
With the static trade-off theory, a firm’s debt payments are tax deductible and there is less risk involved in taking out debt over equity, debt financing is initially cheaper than equity financing. This means a company can lower its weighted average cost of capital (WACC) through a capital structure with debt over equity. However, increasing in the amount of debt also increases the risk to a company, somewhat offsetting the decrease in the WACC. Therefore, the static trade-off theory identifies a mix of debt and equity where the decreasing WACC offsets the increasing financial risk to a company. This model is pertaining to a company’s optimal capital structure which is the optimal level of debt is found at the point where additional debt would cause the costs of financial distress to increase by a greater amount than the benefit of the additional tax shield. The tax rate cannot be represented in a single-period model. Investors are risk-neutral and face a progressive tax rate on end-of-period wealth from bonds. Dividends and capital gains are taxed at a single constant rate. Risk neutrality induces the investor to invest into whichever security that offers the better expected after-tax rate. This model is static even the firms in the real world operate over many periods. The aspect of static modelling are particularly important in order to test the theory which is the role of retained earnings. Retained earnings represent the equity and profitable firms own this equity. Usually the more profitable a firm is, the lower its leverage will be (Murray & Vidhan,
Open Document