The Trade-Off Theory And The Capital Theory Of Capital Structure

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2.1.2. The Trade-off Theory:-
In all of capital structure theories, a decision maker managing a firm evaluates the various costs and benefits of alternative leverage plans. Often it is assumed that an interior solution is obtained so that marginal costs and marginal benefits are balanced. The trade-off theory of capital structure refers to the concept that a firm chooses how much debt finance and how much equity finance to use by balancing the costs and benefits.

The trade-off theory grew out of the debate over the Modigliani-Miller theorem. When corporate income tax was added to the original irrelevance, this created a benefit for debt in that it acts to shield earnings from taxes. Since the firm’s objective function
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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 …show more content…
Stieglitz’s model is not a trade-off theory since he took the harsh step of assuming away uncertainty. The first dynamic models to consider the tax savings versus bankruptcy cost trade-off are Kane et al. (1984) and Brennan and Schwartz (1984). Both analyzed continuous time models with uncertainty, taxes, and bankruptcy costs, but no transaction costs. Since firms react to negative disturbance immediately by rebalancing costless, firms maintain high levels of debt to take advantage of the tax

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