The trade-off theory is derived from the debate over the Modigliani-Miller theorem. Modigliani-Miller (1963) accounts for corporate income tax into their original theorem. This created a benefit for using debt as it shields taxable income. They argue that corporate tax allows for the deduction of interest payments in calculating taxable income. As a result, the use of debt will increase the firm’s after-tax cash flow. This means that profitable firms should use debt to shield their income from tax. This would imply that a firm would use 100% debt financing.
However, Modigliani-Miller (1958) failed to take into account the agency costs and bankruptcy costs associated with debt. Using debt carries additional risk, which means that it is not optimal to finance using debt alone. One of the main costs of debt is the threat of financial distress. These costs occur when a company uses so much debt that it cannot meet its financial obligations. According to Warner (1977) and Barclay et al. (1995), financial distress has both direct and indirect costs. These direct costs include legal and administrative costs of liquidation. Indirect costs could include the loss of customers and suppliers. Based on previous analysis by Bradley et al. (1984), firms with volatile earnings are more likely to face the costs associated with financial distress. This is because the possibility of a firms earnings dropping below their debt obligations is higher, meaning that these firms have less leverage. This makes it unattractive for firms to have too much debt.
The trade-off theory can be broken down into two parts. The first is known as the static trade-off theory. Frank and Goyal (2005) , defines a firm to follow this if :
“A firm’s leverage is determined by a single period trade-off between the tax benefits of debt and the deadweight costs of bankruptcy.”
The trade-off theory goes back to Kraus and Litzenberger (1973), which implies that a firm evaluates the various...
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