The Static Trade-Off Theory Analysis

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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

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