The Trade Off Theory is an important theory while studying the Financial concepts. It explains that the companies or firms are generally financed by both equities and debts. The TOT deals with the two main concepts, namely cost of financial distress and concept of agency costs.
The Financial distress and Agency costs concepts
As per Modigliani and Miller (1958), the attractiveness of debt falls with the personal tax on the interest income. A firm would usually face financial distress when the firm is unable to cope with the debt holders' obligations. If the firm faces an ongoing failure in making payments to the debt holders, the firm can even be insolvent. The direct cost of financial distress refers to the cost of insolvency of a company. The assets of the firm may be required to be sold at distress price once the proceedings of the insolvency starts. This is generally much lower than the current values of the assets. A massive amount of administrative and legal costs are also involved in the insolvency. Even if the company is not running at a loss, the financial distress of the company may crop up a number of indirect costs like cost of employees, cost of customers, cost of suppliers, cost of investors, cost of managers and shareholders. The firms may often experience clashes of interests with the management of the firm, debt holders and shareholders. These disputes generally raise the issues of agency. These in turn give rise to the agency costs. The agency costs may have a negative influence on the capital structure of a firm.
The optimum capital structure
The purpose of the TOT of capital structure is to describe the strategy of the firms to finance their investments sometime by equities and sometimes by debts. The TOT also studies the advantages and disadvantages of equity and bond financing. TOT actually allows the cost of bankruptcy to exist. Normally, TOT affirms the existence of an optimal capital structure. This indicates the level firm has to reach so as to maximize their value. The TOT mainly focuses on the benefits and costs related to debt. The benefits include the tax deductibility of interest paid (Modigliani and Miller, 1958), whilst the costs involves essentially an excessive amount of debt resulting into bankruptcy costs (Kraus and Litzenberger, 1973). Therefore firm set a target level for their debt-equity ratio which in turn balances the tax advantages of additional debt against the costs of possible financial distress.
TOT claims that there is an advantage to debt financing, the tax benefits of debt and there is a cost associated, the costs of financial distress including bankruptcy of debt and non-bankruptcy costs. The marginal benefit of a further rise in debt falls as debt rises. As such, the marginal cost increases. Hence a firm wishing to optimize its overall value will focus on this trade-off when designating how much debt and equity to use for financing.
The major benefit of debt financing is that it provides a tax shelter that increases the available remaining to be distributed to shareholders of equity. Nevertheless, the main disadvantage related with debt financing is the risk of bankruptcy (Warner, 1977; Haugen and Senbet, 1978, Andrade and Kaplan, 1998). Increased levels of leverage, while resulting in the availability of a larger tax shields also necessitate a higher cost line of financial distress. The company is trying to trade-off between the size of the tax shelter and financial distress costs. Higher probability of financial distress is in terms of start-ups and high growth businesses. The company is exposed to the risk of uncertain cash flow streams and low tangible asset base. Therefore, these type of companies should not place high confidence on the debt in their capital structure. On the other hand, firms with a stable revenue stream and sound asset base facing a lower risk of bankruptcy. This company can apply a moderately higher level of leverage in their capital structure.
In its broadest term, the static trade-off theory derives from the prediction that firms maximise their value by maintaining a target debt ratio through minimising the cost of market imperfections. It predicts a cross-sectional relation between debt ratios and asset risk, asset type, profitability and tax status. The static tradeoff theory has managers seeking for optimal capital structure, with any deviations from it will result in a mean-reverting behaviour. As described earlier, this theory stems from the modifications of the original irrelevance hypothesis (MM, 1958) and the documentations from the tax-related proposition (MM, 1963; Miller, 1977; Modigliani, 1982; Miller, 1988). This trade-off theory proposes a corporate debt policy that requires an optimal balance between present value of tax savings from the tax-deductibility feature of interest and the present value of personal tax (Miller, 1977), agency costs (Jensen & Meckling, 1976), and potential bankruptcy costs (Stiglitz, 1969; Chen & Kim, 1979). Titman and Wessels (1988) who extend this optimal theory by using a factor-analytic technique rather than the conventional regression approach also report consistency with the static trade-off theory.
In addition, there are several opinions put forward on the relation between optimal capital structure and the tax-based presumptions. DeAngelo and Masulis (1980) present a theory of optimal capital structure that is motivated by corporate tax shield substitutes for debt such as accounting depreciation, depletion allowances and investment tax credits. DeAngelo and Masulis suggest that regardless of the leverage-related costs, firms can have a unique interior optimal level in the presence of these corporate tax shield substitutes. Lewis (1990) on the other hand, implies that in a world of market perfection except for taxation, a firm may have a set of debt ratios, which are consistent with the value maximisation objectives. He claims that any debt structure that produces a consistent series of promised interest payments would result in the same market value. In the effort to explain the tax advantage of debt, Berens and Cuny (1995) offer a different view of optimal capital structure. They argue that there are many optimal capital structure levels when referring to the choice of debt levels over time. However, until today, no consensus has emerged about the tax-based predictions, and the opinions thus far are not unanimous (Fama & French, 1998; Graham, 2000).
