Capital Theory And Trade-Off Theory Of Capital Structure
Modigliani and Miller introduced the tax benefit of debt. Later it led to an optimal capital structure given by the trade-off theory. According to M& M, the attractiveness of debt declines with the personal tax on interest income. When the firm is unable to cope with the obligations of debt holders, it experiences financial distress. If the firm continues to fail in making payments to the debt holders, it …show more content…
95% of the empirical papers look at the conflict between the managers and shareholders while others look at conflicts between the debt holders and shareholders. Both are equally important to explain how the agency theory and the Trade-off theory of capital structure are related with each other.
Direct cost of financial distress refers to the insolvency cost of a company. Once the proceedings of insolvency start, the assets of the firm may be needed to be sold at a distress price, which is normally much lower as compared to the current values of assets. A huge amount of administrative and legal cost is also associated with insolvency. Even if the company is not insolvent, the financial distress of the company may include a number of indirect costs including, cost of employees, cost of suppliers, cost of customers, cost of investors, cost of shareholders and managers.
The firms may sometimes experience a dispute of interests among the management of the firm, debt holders and shareholders. These disputes generally give birth to agency problems that in turn give rise to the agency costs. The agency costs may affect the capital structure of a firm. It is set up as a competitor theory of the pecking order theory of capital …show more content…
With the increase in debt marginal benefit of further increases in the debt declines while the marginal cost increases, so that a firm which is optimizing its overall value will focus on the trade-off when choosing how much debt and equity to use for financing. As, using equity is initially more expensive than debt because it is ineligible for the same tax savings, but becomes more favourable as compared to the higher levels of debt because it does not carry the same financial risk.
Another trade-off consideration to take into account is that the interest payments can be written off, dividends on equity that tare usually issued by a firm cannot. Combine with the fact that issuing new equity is often seen as a negative signal by the market investors, which can decrease value and returns of a firm.
As further capital is raised and the marginal costs increase, the firm must find a fine balance in whether it should use debt or equity after internal financing when raising new