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 benefits and costs of different leverage plans. Financial managers often think of the firm’s debt-equity decision as the trade-off between the tax benefits of using debt and the cost of financial distress. The company should reach a decision so that marginal costs and benefits are balanced. This threshold of debt is generally called the optimal (target) level of capital structure and is defined by the trade-off between costs of debt and its benefits. More precisely, it will be at the point where the marginal benefits of each additional unit of debt equal to its marginal costs.
The trade-off theory of capital structure recognises that target debt ratios of can vary from firm to firm. Companies with safe, tangible assets and a high amount of taxable income should favour high leverage ratios. Companies that have low profits and risky, intangible assets should prefer to rely primarily on equity financing.
The second part of the trade-off theory is known as the target adjustment behaviour (Frank and Goyal 2005). This focuses on the deviations in from the target level of debt and this is gradually obtained over time. Under the static trade-off theory, financial managers look to obtain optimal capital structure. Random events can occur which will move the company away from it. As long as the optimal debt-equity ratio remains stable, then the firm should move gradually back and mean reverting behaviour can be observed.
According to Myers (1984), a firm will set a target debt-equity ratio balancing the debt tax advantages against the costs of potential bankruptcy. If there were no costs associated with adjusting capital structure, then companies should always be at their target debt-equity ratio. In reality there are associated costs, which results in delays in adjusting to the optimum (adjustment costs). Random events may occur that will move firms away from their target capital structure. In practice, it should be possible to observe random differences in debt-equity ratios among firms with the same target debt levels.
According to Myers (1984) and Flannery and Rangan (2006), the presence of adjustment costs may restrict the firms’ ability to revert back to their target capital structure immediately, suggesting the occurrence of partial adjustment toward the target level. The partial adjustment mechanism allows for the firms’ observed leverage ratio not always being equal to their target level. This mechanism suggests that firms make leverage adjustment if the costs of being away from the target leverage ratio are higher than those of moving toward the target; otherwise it is not rational for these firms to make leverage adjustments, because the adjustment costs will be large enough to cancel out the benefits of moving toward the target level. However, it assumes that adjustment towards the target occurs at symmetrical rates. No distinction is being made between the below target leverage ratio and the above-target leverage ratio, suggesting that the adjustment costs as well as the benefits of increasing and reducing leverage are symmetrical.