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Trade-Off Theory

Step-by-Step Guide to Understanding the Trade-Off Theory of Capital Structure

Last Updated October 1, 2023

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Trade-Off Theory

What is the Trade-Off Theory of Capital Structures?

The trade-off theory is based on the assumption that corporations should optimize the mix of debt and equity in their capital structure to minimize their weighted average cost of capital (WACC).

The optimal capital structure of a firm is attained when the percentage contribution from debt and equity is optimized to maximize the value of a firm, while the cost of capital is minimized.

The trade-off theory states that the optimal capital structure is a balancing act between reaping the marginal benefit of the interest tax shield and the risk of financial distress.

If illustrated on a graph, the optimal capital structure is the point at which the weighted average cost of capital (WACC) is at its lowest point (and the firm valuation is at its peak).

Since the cost of capital (WACC) is the blended minimum required rate of return representative of all stakeholders, such as equity shareholders and lenders, a lower WACC causes the valuation of a firm to increase (and vice versa for a higher WACC).

In short, the trade-off theory is the notion that corporations should strive to achieve the right balance in capital weights to maximize their firm value and create positive stakeholder value.

Learn More → The Trade-Off Theory of Corporate Capital Structure (Source: Oxford University)

How Does the Trade-Off Theory Work?

Broadly put, there are two sources of funding used by corporations to fund their operations, e.g. working capital needs and purchase of fixed assets (PP&E).

  • Debt Capital → The borrowing of capital from lenders for a pre-determined period in exchange for the obligation to meet periodic interest payments and repay the original principal in full at maturity.
  • Equity Capital → The issuance of shares that represent partial ownership in the company’s common equity.

Each source of capital has advantages and disadvantages that must be carefully considered by corporations.

In particular, the primary benefit of debt financing is the interest tax shield, where the interest paid on debt is tax-deductible and reduces the pre-tax income (EBT) on the income statement.

The drawback to using debt is that the financial obligations represent contractual commitments with fixed costs. Therefore, the decision to rely on leverage causes the risk of financial distress to rise proportionally.

Unlike debt financing, raising capital via equity financing does not place the underlying issuer with any mandatory obligation to issue dividends to shareholders – albeit the management team must act in the “best interests” of their shareholders.

Therefore, debt financing is considered a “cheaper” source of capital, whereas equity financing offers more flexibility and control over the existing ownership structure to manage the risk of dilution.

With that said, the trade-off theory states that the optimal capital structure of a corporation can be determined by balancing the tax-saving benefits from debt and bankruptcy risk.

Hypothetically, if there were no financial distress costs or bankruptcy risk from the use of debt, the optimal capital structure would be comprised of all debt. However, that unfortunately is not the case in the real world.

The following graph illustrates the relationship between firm value and financial leverage. Notably, the inflection point at which the maximum firm value is reached reflects the trough of the cost of capital.

Trade-Off Theory – Optimal Capital Structure

“The Static Theory of Capital Structure” (Source: Brealey, Myers, & Allen)

What Factors Determine the Trade-Off Theory?

The optimal capital structure occurs at the point where the firm’s value is maximized, while the weighted average cost of capital (WACC) is minimized.

The trade-off theory of capital structure states that the management team of a company must consider the following factors to optimize their firm valuation:

  • Interest Tax Shield (i.e. “Tax Savings”)
  • Risk of Default
  • Cost of Bankruptcy
  • Financial Distress
  • Operating Leverage

Given that corporations have the economic incentive to maximize their firm valuation (and stock price), the interest-tax shield benefits are a method to achieve that core objective.

But as mentioned earlier, the addition of debt into a company’s capital structure increases its risk of default and potentially becoming distressed, which can ultimately end in bankruptcy proceedings.

Once a company files for bankruptcy, the Court can decide whether a reorganization (Chapter 11) or liquidation (Chapter 7) is appropriate. The decision of the Court is contingent on which route is most beneficial to creditors in terms of their recovery rates, i.e. recoup their initial capital.

If the percentage of debt in a company’s capitalization is low, the risk of default is also low, so the minimal leverage enables the company to benefit from the interest tax shield.

However, increasing the percentage of debt – where leverage becomes a more significant source of financing – will inevitably reach an inflection point, whereby the tax savings are offset by the heightening risk of financial distress.

For corporations with high credit risk – as determined by financial metrics like the debt to equity ratio (D/E) and interest coverage ratio – the aforementioned point is met sooner.

Thus, the firms deemed to be at a higher risk of default (e.g. low debt capacity, low profitability, cyclical cash flows) have an optimal capital structure composed of less leverage compared to firms with high credit ratings and strong fundamentals.

What are the Components of the Trade-Off Theory?

The optimal capital structure is achieved when the allocation of debt and equity maximizes the firm value and minimizes the cost of capital (WACC) per the trade-off theory.

The process of incrementally increasing the financial leverage in the capital structure of a company, and the impact on firm valuation (and WACC) are as follows.

  1. Initially, as a firm introduces debt into its capital structure, the value of the firm increases from the interest tax shield.
  2. Gradually, as more debt is placed on the company, the tax benefits continue to rise.
  3. But the tax shield is beneficial only until a certain point, which is when the interest expense burden exceeds the borrower’s operating income (EBIT).
  4. If a company’s interest expense equals its operating income, there is no taxable income, assuming there are no non-operating items.
  5. Since there are no tax savings from increasing the debt load – which determines the interest expense – the benefits halt.
  6. Beyond the inflection point, the company is now no longer benefiting from the interest tax shield, and instead at greater risk of default, as the debt burden might be unsustainable – hence, the cost of capital reverses course and starts to rise in an upward trajectory (and firm value declines).

The stage at which the cost of capital (WACC) is at its lowest point reflects a company’s optimal capital structure, which is the ratio of debt and equity that a company should target in the long run.

The optimal debt and equity weights in the target capital structure are subjective measures because risk and return are abstract concepts specific to the individual – not to mention, the formula to calculate the cost of capital (WACC) requires the market values of a company’s debt and equity.

Namely, the market values of debt and equity constantly fluctuate based on the state of the financial markets, investor sentiment, and economic conditions.

Therefore, the optimal capital structure under the trade-off theory is not constant, given the underlying variables that determine the cost of capital (WACC) and the appropriate capital weights.

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