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The trade-off theory is one of several
theories that attempts to explain the capital structure of corporations (i.e. the
forms of financing for their operations, investments and growth). Most studies
conducted on the field of capital structure focus on the proportions of debt
and equity on the balance sheet. As stated by Myers (1984), there is no clear
answer on what exactly determines the way companies finance their business and
investments. Although there is a lack of an universal explanation on the choice
of proportions between debt and equity, several conditional theories exists. Some
of the most widely used theories on capital structure are Modigliani and Miller’s
theorem, the pecking order theory, the free cash flow theory and the trade-off theory.
The theory of Modigliani
and Miller (1958) in essence states that a corporations’ market value is calculated
using its earning power and the risk of its underlying assets and is independent
of the way it finances investments or distributes dividends. This leads to the
capital-structure irrelevance proposition, suggesting that there is no
difference in what form (i.e. what capital structure) a corporation finances
its operations, growth and investments in perfect and frictionless markets.  The choice between debt and equity financing
has no material effects on the value of the firm or on the cost or availability
of capital. They assumed perfect and frictionless capital markets, in which
financial innovation would quickly extinguish any deviation from their
predicted equilibrium.

The logic of the Modigliani and Miller (1958) results is now widely
accepted. Nevertheless, financing clearly can matter. The chief reasons why it
matters include taxes, differences in information and agency costs. Theories of
optimal capital structure differ in their relative emphases on, or
interpretations of, these factors.  The trade-off
theory states that firms seek debt levels that balance the tax advantages of
additional debt against the costs of possible financial distress. This theory predicts
moderate borrowing by tax-paying firms. The pecking order theory says that the
firm will borrow, rather than issuing equity, when internal cash flow is not
sufficient to fund capital expenditures. Thus the amount of debt will reflect
the firm’s cumulative need for external funds. The free cash flow theory says
that dangerously high debt levels will increase value, despite the threat of
financial distress, when a firm’s operating cash flow significantly exceeds its
profitable investment opportunities. The free cash flow theory is designed for
mature firms that are prone to overinvest. It can be said that the tradeoff
theory emphasizes taxes, the pecking order theory emphasizes differences in
information, and the free cash flow theory emphasizes agency costs. For the purposes of this paper, we
shall focus solely on the trade-off theory and discuss the other theories only
in lesser context.1  

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1.1 Background of the trade-off theory

Modigliani and Miller’s (1958)
article regarding the financing of corporations and their firm value was a big
game-changer. Their first proposition was that, in a world without transaction
costs and where citizens and corporations can borrow funds at the same interest
rate, a firm’s value would be the same if it was leveraged as if it was
unlevered. In the second proposition, Modigliani and Miller (1958) show that
the required return on equity increases as the debt-to-equity relation
increases. However, more leverage leads to more financial risk. According to
the authors, the relationship between debt-to-equity and expected return is
linear. This goes back to the Modern Portfolio Theory by Markovitz (1952), who
states that investors are risk averse. Therefore they are only willing to take
on more risk if that risk taking is compensated by a higher expected return. In
Modigliani and Miller’s (1958) theorem this means that a firm with high
leverage will increase its expected return to investors to compensate for the
risk. While Modigliani and Miller’s (1958) first and second theorem did not
take taxes into account, they later published an article that did. Modigliani
and Miller (1963) wrote that leveraged financing has an advantage through the
tax shield. Interest on debt financing is paid before taxes, unlike dividend
paid to shareholders. This tax advantage would therefore increase the expected
after tax returns to investors when using debt financing. According to Kraus and
Litzenberger (1973), Modigliani and Miller assumed that the corporation was
able to pay interest to its debtors. Therefore, Kraus and Litzenberg (1973)
developed this theory and laid the ground for the so-called Trade-off Theory.
The tradeoff is between the tax advantage of debt as a source of financing and
the net present value of bankruptcy costs. Increased leverage makes for a
greater tax shield, but the financial risk and thereby bankruptcy costs,
increases as well. The amount of debt used for financing depends on the
corporation’s individual situation and the trade-off is between tax advantages
and financial distress (Kraus & Litzenberg 1973, Scott 1977, Kim 1978).


2. The trade-off theory

The critique by Kraus and Litzenberg
(1973), regarding the firm’s ability to pay interest on its debt, led to the
forming of a more developed version of the theory, the Trade-off Theory.
Modigliani and Miller (1958) assumed perfect capital markets and therefore the
firm’s market value was independent of its capital structure. However, Kraus
and Litzenberg (1973) concluded that bankruptcy penalties and the taxation on
corporate profits are an example of imperfect markets.

Modigliani and Miller (1963) assumed that firms
can earn its debt obligation with certainty, while Hirshleifer (1966) assumed
an absence of bankruptcy penalties. Kraus and Litzenberg (1973) opposed both
these assumptions and instead combined the two, resulting in a theory of a
trade-off between

1 Myers 1984, Myers 2001

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