Static Trade-Off Theory

ACCA P4考試：Static Trade-Off Theory

1 Use of Debt Finance

The trade-off theory of capital structure refers to the idea that a company chooses how much debt finance to use by balancing the relative costs and benefits of debt.

The relevant benefit of debt is the tax shield on interest payments.

The relative costs of using debt include:

Agency costs—as financial gearing rises, debt contracts include increasingly restrictive covenants (e.g. forcing the firm to stay in low-risk projects or limiting dividend payments). The resulting loss in potential shareholder wealth is referred to as agency costs.

Financial distress costs—when stakeholders perceive the level of gearing to be dangerous the firm's cost of operating the business may rise as suppliers refuse credit, staff leave, potential customers lose faith in products sold under warranty or guarantee, etc.

Bankruptcy costs—if a firm defaults on its debt it will either incur the costs of going through a capital reconstruction scheme or the costs of being liquidated.

2 Comparison With MM and Pecking Order Theory

MM only considered the benefit of using debt (and hence concluded that the firm's value would continuously rise with financial gearing). The static trade-off theory also considers the costs and attempts to explain why, in practice, firms use less debt than expected by MM.

The pecking order theory does not suggest that there is an optimal debt-to-equity ratio. However, static trade-off theory suggests that there is an optimal point at which the marginal cost of taking on more debt equals the marginal benefit.

3 Conclusion

The conclusion of static trade-off theory is, therefore, that an optimal capital structure does exist and the related cost of capital and valuation graphs would be similar to that of the traditional view. However, the optimal debt-to-equity ratio suggested by static trade-off theory would not necessarily be exactly the same as that of the traditional view of capital structure.