TRADE - OFF THEORY

“THE TRADE-OFF THEORY OF LEVERAGE”, in which firms’ trade off the benefits of debt financing against the higher interest rates and bankruptcy costs. A summary of the trade-off theory is expressed in figure. Here are some observations about the figure:

THE TRADE-OFF THEORY OF LEVERAGE

 

1. The fact that interest is a deductible expense makes debt less expensive than common or preferred stock. As a result, using debt causes more of the firm’s operating income (EBIT) to flow through to investors. Therefore, the more debt a company uses, the higher its value of stock prices. Under the assumptions of the MM(Modigliani and Miller), a firm’s stock price will be maximized if it uses virtually 100% debt and the line labeled “ MM result incorporating the Effect of Corporate Taxation” in figure express the relationship between stock prices and debt under their assumptions.
2. In the real world, firms rarely use 100% debt. Trade – off theory advocates argue that firms limit their use of debt to hold down bankruptcy related costs.
3. There is some threshold level of debt , labeled in figurea.      
   
   1. BELOW : The probability of bankruptcy is so low as to be immaterial.b. 
   2. BEYOND : bankruptcy related cost become increasingly important and they reduce the tax benefits of debt at an increasing rate.c. 
   3. FROM TO : bankruptcy related costs reduce but do not completely offset the tax benefits of debt, so the stock price rises as the debt ratio increases.d. 
   4. BEYOND : bankruptcy related costs exceed the tax benefits, so from this point on increasing the debt ratio lowers the value of the stock.
4. Therefore,   is the optimal capital structure. Of course,  and  vary firm to firm, depending on their business risks and bankruptcy costs.
5. While theoretical and empirical work supports the general shape of the curves in figure, these graphs must be taken as approximations, not as precisely defined functions.
6. Another disturbing aspect of capital structure theory as expressed in figure is the fact that many large successful firms, such as INTEL and MICROSOFT, use far less debt than the theory suggests.