MR Hongyu

MR Hongyu

The Trade-Off Theory of Capital Structure
Financial managers often think of the firm’s debt–equity decision as a trade-off between interest tax shields and thecosts of financial distress. Of course, there is controversy about how valuable interest tax shields are and what kinds of financial trouble are most threatening, but these disagreements are only variations on a theme. Thus, Figure 18.2 illustrates the debt–equity trade-off.

T his trade-off theory of capital structure recognizes that target debt ratios may vary from firm to firm. Companies with safe, tangible assets and plenty of taxable income to shield ought to have high target ratios. Unprofitable companies with risky, intangible assets ought to rely primarily on equity financing.

If there were no costs of adjusting capital structure, then each firm should always be at its target debt ratio. However, there are costs, and therefore delays, in adjusting to the optimum. Firms cannot immediately offset the random events that bump them away from their capital structure targets, so we should see random differences in actual debt ratios among firms having the same target debt ratio.

All in all, this trade-off theory of capital structure choice tells a comforting story. Unlike MM’s theory, which seemed to say that firms should take on as much debt as possible, it avoids extreme predictions and rationalizes moderate debt ratios. Also, if you ask financial managers whether their firms have target debt ratios, they will usually say yes—although the target is often specified not as a debt ratio but as a debt rating. For example, the firmmight manage its capital structure to maintain a single-A bond rating. Ratio or rating, a target is consistent with the trade-off theory.20

But what are the facts? Can the trade-off theory of capital structure explain how companies actually behave?

The answer is “yes and no.” On the “yes” side, the trade-off theory successfully explains many industry differences in...

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