The Dynamic Trade Off Theory And The Dynamic Trade-Off Model
When debt-equity ratio is high, it doesn't mean bad thing, it is because debt is a cheaper source compared to equity. When the finance is risky at some level, by increasing the debt to equity level, it can help company to reduce the cost of capital. The reason is because when debt to equity level increases, the source of finance is more expensive, this can lead …show more content…
The Dynamic Trade-Off Theory
Dynamic trade-off theory was developed by Fischer, Heinkel and Zechner on 1989, they were the one of the first to develop a model in, which the companies may diverge from the optimal capital structure. Within the last ten years, many companies were unsatisfied with the static trade-off model, which lead to many contributions to dynamic trade-off theory. Dynamic trade-off theory treats companies’ capital structure as a continuous decision that involves investment decisions and restricting costs. This may cause companies to move away from the optimal capital structure for a longer periods of time.
Fischer, Heinkel and Zechner suggested that instead of an optimal capital structure, companies have an optimal capital structure which they let the capital structure fluctuate. The model developed by Fischer, Heinkel and Zechner offers multi-period dynamic perspective to the financial decisions made for the companies, but doesn’t offer much perspective on what implications it might have to empirical research. On 2007, Strebulaev developed a dynamic trade-off model that combines the costs associated with the capital structure adjustments and shows by simulation that the model that consistent with observed capital structures. Strebulaev found that there are distinction between companies’ capital structure at refinancing points and their actual capital structure when data is collected. The models which developed by Fischer, Heinkel and Zechner and Strebulaev offer some appealing characteristics, but it look only at costs associated with the act of adjusting the capital structure and treats companies investment decisions as independent of their financing