Trade-Off Theory

From Wikipedia, the free encyclopedia

The Trade-Off Theory of Capital Structure is a theory in the realm of Financial Economics about the corporate finance choices of corporations. It s purpose is to explain the fact that firms or corporations usually are financed partly with debt and partly with equity. It states that there is an advantage to financing with debt, the Tax Benefit of Debt and there is a cost of financing with debt, the Bankruptcy Cost of Debt. 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. Although the empirical success of the alternative theories is often dismal,^[1]^[2] the relevance of this theory has often been questioned. Miller 1977^[3] for example metaphor speaks of the balance between those two as equivalent to the balance between horse and rabbit content in a stew of one horse and one rabbit. Other critics have suggested it is the mechanical change in asset prices that makes up for most of the variation in capital structure.^[4]