Trade Off Theory Essay

Several theories were derived from the Modigliani and Miller (MM) theory. The MM theory was created in a utopian world for corporations, with no taxes, no bankruptcy or brokerage costs, and no impacts by the use of debt, to name a few assumptions the MM theory made. Although the MM theory is unrealistic, it helped firms apply and change the different assumptions to determine which capital structure was the best for the firm, and how these assumptions would impact the firm.

The Trade-Off Theory takes bankruptcy, and the threat of bankruptcy, costs into account. When organizations use too much debt to finance their assets, or organizations with more unpredictable earnings, have a greater risk of bankruptcy. The trade-off theory suggests that organizations would use less debt to finance the organization due to the cost …show more content…
This theory limits the amounts of free cash flow to managers and finances the organization with more debt. This is done to limit the possibility of managers’ spending money in ways that do not benefit the shareholders. There is a higher risk of bankruptcy due to high amount of debt being used. Managers also may end up being too constrained with the high debt and will be unwilling to invest in project they may otherwise invest in.

The market timing theory is a theory in which managers attempt to “time the market” in order to sell debt when interest rates are low and issue equity when stock market prices are unusually high. The managers that use this theory do not think market equilibrium exists. They take what they believe to be the organization’s fundamental value into account and determine if the prices are high or interest rates are low. They do not have asymmetric information; they look at market trends and determine if the market is believed to be