The Static Trade-Off Theory Analysis

Better Essays
A firm can finance their investments using two financing types, debt or equity. For more than half a decade, scholars have been debating about the optimal amount of debt and optimal amount of equity that maximize the market value of a firm. Capital structure is defined as the type of the funds, equity capital or debt capital, a company uses to finance its operations and investments. According to a survey among CFOs of 392 companies, only 19 percent of the companies avoid having a target capital structure ratio (Grahama & Harvey, 1999). This being said, capital structure theories are significant for companies. Empirical evidence shows that the financing types among different countries vary significantly (Jones & Zeitlin, 2008), as depicted in …show more content…
Figure 3 provides a graphical illustration of the Static Trade-off Theory - the trade-off between the PV of tax benefit of debt and the PV of financial distress cost. Point B* is where the two offsetting factors produce the maximum market value of the firm, and that represents the optimal amount of debt for the company (based on the x-axis). Due to the complexity to express the financial distress cost using a formula, there is yet a mathematical way to calculate the optimal amount of debt (Ross, et al., 2013). This makes the Static Trade-off Theory challenging to be implemented in the real world. 5. EMPIRICAL EVIDENCE
Apart from the Miller and Modigliani theorem, this paper presented two other alternative theories of capital structure. Altogether, the three theories have three different and conflicting connotations:
• M & M Proposition I states that market value of the company is irrelevant of the composition of the capital structure;
• Static Trade-off Theory states that there is a negative relationship between debt and market value of the firm; and
• Pecking Order Theory states that there is a positive relationship between debt and market value of the
…show more content…
Furthermore, the paper draws an analogy with two other theories of capital structure, the Pecking Order Theory and the Static Trade-off Theory. Critics of the M & M Proposition I point out the assumptions of the theorem as significant limitations. The assumptions of the M & M theorem stimulated scholars to get involved in a number of theoretical and empirical studies in trying to build upon the findings from Miller and Modigliani. In particular, two theories gathered a lot of attention, the Pecking Order Theory and the Static Trade-off Theory. In a nutshell, these two theories encompass conflicting outcomes with one another; however, they both indicate that leverage impacts the market value of the firm – unlike the M & M Proposition I. To assess the validity of these three theories, empirical studies come to place. There is a wide agreement among empirical studies that Static Trade-off Theory is valid. That is, debt capital decreases the market value of firms.
Future studies should try to create a comprehensive approach of the effect of debt in market value of firms. Specifically, they should try to address all the assumptions (or better say, limitations) of M & M Proposition I, listed in section 2.1 of this paper. Current studies address one limitation at a time, therefore still comprehending other limitations

Related Documents

  • Decent Essays

    Historical cost accounting provide information about how well or badly managements do their duty to shareholders. Among the comparisons between fair value accounting and historical cost accounting before, the advantages of fair value accounting is more than those of historical cost accounting. In my view, I prefer balance sheet approach at fair value. Fair value accounting has many advantages which are discusses above and also is a trend under regulation. The main weakness in fair value accounting is that when market is not perfect, how to get fair value from market.…

    • 1161 Words
    • 5 Pages
    Decent Essays
  • Decent Essays

    As Grigore and Ştefan-Duicu (2013) state, according to agency theory the optimal capital structure of a firm is the outcome of a reconciliation of the conflicts of interest between the creditors, the managers and the shareholders of the firm. A lot of effort has been made so far to identify the determinants of the capital structure, but still there is not a generally accepted view. Furthermore, the stability of the capital structure is another important issue that concerns modern finance theory (DeAngelo and Roll 2015) The purposes of this paper are firstly to provide some insight on the determinants of the corporate capital structure and secondly to examine the extend at which it remains stable over the time. Literature review As mentioned in the previous chapter, the efforts of determining how the capital structure decision is influenced were concentrated by removing the strict assumptions of Modigliani and Miller irrelevance theorem (1958). In their subsequent work, Modigliani and Miller (1963) find that in the presence of taxes, leverage would create a tax shield, through the interest payments (trade-off…

    • 995 Words
    • 4 Pages
    Decent Essays
  • Decent Essays

    It also considers that managers are bound by cognitive ability, and that affects how they perceive and react to different market conditions. Therefore, the question posed in this paper is why do production firms ‘irrational’ decisions, such as reference points and loss aversion, affect a firm’s entry and exit decisions, self-selection of entrants, and the market structure that emerges. Thus the proposed answer by Fershtman is that cognitive ability, reference points and tendency for loss aversion, of the firm’s managers, must be taken into account when discussing firm behaviour. Although this is valuable information, it is not necessarily surprising. It builds off the idea that not only are reference points and loss aversion tendencies the cause for firm’s irrational behaviour but the cognitive ability of the firm’s management is, as well.…

    • 1204 Words
    • 5 Pages
    Decent Essays
  • Decent Essays

    Agency costs derive from conflicts of interest between the different stakeholders of the firm and because of ex post imbalance information (Jensen and Meckling (1976) and Jensen (1986)). Hence, incorporating agency costs into the static trade-off theory means that a firm determines its capital structure by trading off the tax advantage of debt against the costs of financial distress of too much debt financing and the agency costs of debt against the agency cost of equity. Many other cost factors have been assumed under the trade-off theory, and it would difficult to discuss them all. Therefore, this discussion ends with the assertion that an important prediction of the static trade-off theory is that firms target their capital structures. if the actual leverage ratio differ from the optimal one, the firm will adapt its financing behavior in a way that brings the leverage ratio back to the optimal…

    • 1588 Words
    • 7 Pages
    Decent Essays
  • Decent Essays

    Likewise, the liabilities also reflect their historic cost, so that the equity of the FI is the book value of the stockholders’ claims instead of the market value of those claims. So if a FI uses the book value concept, invariably, this value does not equal the market value of equity which is the difference between the market value of assets and liabilities. This inequality between book and market values of equity leads to false impressions of the true state of their balance sheet when examining the effects of credit and interest rate shocks on a FI and interpreting their position of being economically solvent with a positive net worth when in actuality this can be quite the…

    • 1214 Words
    • 5 Pages
    Decent Essays
  • Decent Essays

    Besides that, they also found that the relationship of stock’s dividend yield on ex-dividend equivalent size of its ex-dividend price decrease is positive. Therefore, they use this consequence as a proof that differential taxes made a preference for capital relative to cash dividends. Thus, they support the clientele hypothesis. There is nothing wrong between views of bird in hand theory or tax preference theory. There just a conflict between these two concepts because in the real world, different countries have different tax rate on dividend and capital gain.…

    • 1454 Words
    • 6 Pages
    Decent Essays
  • Decent Essays

    Underinvestment due to asymmetric information may lead to the cases when some positive NPV projects are not taken into account while the management decides to invest in lower quality projects which may need external financing sources (Myers and Majluf, 1984). Hence, the main concern of shareholders is to ensure that managers run the firm with proper resources in order to maximize its value. This requires shareholders to seek a solution of the principal-agent problem. It is recommended that financing policies should be used as an efficient and economical tool for shareholders to diminish the agency problems (Grossman and Hart, 1980;…

    • 888 Words
    • 4 Pages
    Decent Essays
  • Decent Essays

    Since the value of assets differ, estimates to determine the financial and real value are required. The uncertainty of value for assets is common and a great technique to diminish this is by building better models and creating ranges. In corporate finance, valuation is important due to the process of requesting extra capital from investors. Not all investors, such as fundamental analysts and information traders are interested in valuation in portfolio management.…

    • 1819 Words
    • 8 Pages
    Decent Essays
  • Decent Essays

    Six Sigma asserts these activities have to be investigated as they could represent issues in a business process. Based on these assumptions, a high Z-score in the data would be an indicator of unexpected abnormalities. Thus, this research can assess the effectiveness of data-driven IC by creating a volatility function to quantify the fluctuation of IC activities. The usage of the volatility feature is prevalent in the area of finance and economics. The most famous is the Black-Scholes model, whose generalization is a local volatility model, and the volatility is constant (Black, Scholes, 1973).…

    • 946 Words
    • 4 Pages
    Decent Essays
  • Decent Essays

    They suggested that current ratio is a conventional measurement that used to measure the liquidity and how efficient a firm to pay their current liabilities. At the same time, they found out that current ratio is negatively correlated to the profitability of firms, hence, this means liquidity is adversely impact on profitability. In other words, if the liquidity position of firms is better, then the profitability of firms would drop. Furthermore, they explained that current ratio is the most important measurement of liquidity that affects profitability in Pakistan. Thus, Pakistani firms must face a trade-off in between liquidity or…

    • 1494 Words
    • 6 Pages
    Decent Essays