The trade-off theory is one of severaltheories that attempts to explain the capital structure of corporations (i.

e. theforms of financing for their operations, investments and growth). Most studiesconducted on the field of capital structure focus on the proportions of debtand equity on the balance sheet. As stated by Myers (1984), there is no clearanswer on what exactly determines the way companies finance their business andinvestments. Although there is a lack of an universal explanation on the choiceof proportions between debt and equity, several conditional theories exists. Someof the most widely used theories on capital structure are Modigliani and Miller’stheorem, the pecking order theory, the free cash flow theory and the trade-off theory.

The theory of Modiglianiand Miller (1958) in essence states that a corporations’ market value is calculatedusing its earning power and the risk of its underlying assets and is independentof the way it finances investments or distributes dividends. This leads to thecapital-structure irrelevance proposition, suggesting that there is nodifference in what form (i.e. what capital structure) a corporation financesits operations, growth and investments in perfect and frictionless markets.

 The choice between debt and equity financinghas no material effects on the value of the firm or on the cost or availabilityof capital. They assumed perfect and frictionless capital markets, in whichfinancial innovation would quickly extinguish any deviation from theirpredicted equilibrium. The logic of the Modigliani and Miller (1958) results is now widelyaccepted.

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Nevertheless, financing clearly can matter. The chief reasons why itmatters include taxes, differences in information and agency costs. Theories ofoptimal capital structure differ in their relative emphases on, orinterpretations of, these factors.  The trade-offtheory states that firms seek debt levels that balance the tax advantages ofadditional debt against the costs of possible financial distress. This theory predictsmoderate borrowing by tax-paying firms. The pecking order theory says that thefirm will borrow, rather than issuing equity, when internal cash flow is notsufficient to fund capital expenditures. Thus the amount of debt will reflectthe firm’s cumulative need for external funds.

The free cash flow theory saysthat dangerously high debt levels will increase value, despite the threat offinancial distress, when a firm’s operating cash flow significantly exceeds itsprofitable investment opportunities. The free cash flow theory is designed formature firms that are prone to overinvest. It can be said that the tradeofftheory emphasizes taxes, the pecking order theory emphasizes differences ininformation, and the free cash flow theory emphasizes agency costs.

For the purposes of this paper, weshall focus solely on the trade-off theory and discuss the other theories onlyin lesser context.1  1.1 Background of the trade-off theoryModigliani and Miller’s (1958)article regarding the financing of corporations and their firm value was a biggame-changer. Their first proposition was that, in a world without transactioncosts and where citizens and corporations can borrow funds at the same interestrate, a firm’s value would be the same if it was leveraged as if it wasunlevered.

In the second proposition, Modigliani and Miller (1958) show thatthe required return on equity increases as the debt-to-equity relationincreases. However, more leverage leads to more financial risk. According tothe authors, the relationship between debt-to-equity and expected return islinear. This goes back to the Modern Portfolio Theory by Markovitz (1952), whostates that investors are risk averse.

Therefore they are only willing to takeon more risk if that risk taking is compensated by a higher expected return. InModigliani and Miller’s (1958) theorem this means that a firm with highleverage will increase its expected return to investors to compensate for therisk. While Modigliani and Miller’s (1958) first and second theorem did nottake taxes into account, they later published an article that did. Modiglianiand Miller (1963) wrote that leveraged financing has an advantage through thetax shield. Interest on debt financing is paid before taxes, unlike dividendpaid to shareholders.

This tax advantage would therefore increase the expectedafter tax returns to investors when using debt financing. According to Kraus andLitzenberger (1973), Modigliani and Miller assumed that the corporation wasable to pay interest to its debtors. Therefore, Kraus and Litzenberg (1973)developed this theory and laid the ground for the so-called Trade-off Theory.The tradeoff is between the tax advantage of debt as a source of financing andthe net present value of bankruptcy costs. Increased leverage makes for agreater tax shield, but the financial risk and thereby bankruptcy costs,increases as well.

The amount of debt used for financing depends on thecorporation’s individual situation and the trade-off is between tax advantagesand financial distress (Kraus & Litzenberg 1973, Scott 1977, Kim 1978). 2. The trade-off theory The critique by Kraus and Litzenberg(1973), regarding the firm’s ability to pay interest on its debt, led to theforming of a more developed version of the theory, the Trade-off Theory.Modigliani and Miller (1958) assumed perfect capital markets and therefore thefirm’s market value was independent of its capital structure.

However, Krausand Litzenberg (1973) concluded that bankruptcy penalties and the taxation oncorporate profits are an example of imperfect markets.Modigliani and Miller (1963) assumed that firmscan earn its debt obligation with certainty, while Hirshleifer (1966) assumedan absence of bankruptcy penalties. Kraus and Litzenberg (1973) opposed boththese assumptions and instead combined the two, resulting in a theory of atrade-off between 1 Myers 1984, Myers 2001