Question

Provide an analysis on the Trade-off theory.

Information based on journals on trade of theory.

(I.e. Definition on the theory, practical application of theory (examples)) in 300 words

Answer 1

There are different capital structure theories such as trade off theory, pecking order theory. Trade off theory is based on the idea that the company has to make a trade off between the tax shield that it is receiving from debt and the interest burden that is occurring because of the debt where as pecking order theory focuses on the order in which internal financing, debt and equity are used as a source of funds. The reason why managers choose to add debt in the capital structure is debt is less risky in terms of cost of source and the interest payment on the debt is tax deductible whereas the dividend on equity is not tax deductible. Trade off theory says that companies have to find a level of balance in the manner they are going to use the debt and equity so that the value of the firm is maximized so manger choose to add level of debt in the capital structure to such an extent that the tax benefits is maximized and the interest burden is also not too much and that can happen when the company is able to look at different capital structure, tax benefits and also the ratio such as interest coverage ratios. The debt component is useful but if the company in certain year faces cash crunch then it can cause issue in the payment of interest. Let’s say a company is operating with capital structure of 50% debt and 50% equity, now for some companies such capital structure might work and the interest burden might not be too much, for some companies they can increase the debt and benefit more from the level of debt without significant interest burden and it can also happen that for some companies the interest burden at 50% debt and 50% equity might be high so they need to reduce the debt portion, so the tradeoff theory actually focuses on finding an optimal capital structure where the benefit is maximum and the interest burden is manageable.