Question

Trade-off theory is based on the premise that debt capital has some advantages and disadvantages (hence the trade-off). Discuss the advantages and disadvantages of using debt capital and provide an example of why it may impact on firm value. Additionally, what does trade-off theory imply about capital structure and what empirical evidence does trade-off theory fail to explain.

Answer 1

Advantages of Debt Capital financing:

• Retain control. When you agree to debt financing from a lending institution, the lender has no say in how you manage your company. You make all the decisions. The business relationship ends once you have repaid the loan in full.
• Tax advantage. The amount you pay in interest is tax deductible, effectively reducing your net obligation.
• Easier planning. You know well in advance exactly how much principal and interest you will pay back each month. This makes it easier to budget and make financial plans.

Disadvantages of Debt Capital Financing:

• Qualification: The company and the owner must have acceptable credit ratings to qualify.
• Fixed payments: Principal and interest payments must be made on specified dates without fail. Businesses that have unpredictable cash flows might have difficulties making loan payments. Declines in sales can create serious problems in meeting loan payment dates.
• Cash flow: Taking on too much debt makes the business more likely to have problems meeting loan payments if cash flow declines. Investors will also see the company as a higher risk and be reluctant to make additional equity investments.
• Collateral: Lenders will typically demand that certain assets of the company be held as collateral, and the owner is often required to guarantee the loan personally.

Example why Debt financing may reduce firm value ? As cash flows have to be strong to generate liquidity to bear fixed interest and failure to service such debt shall result into bankruptcy risk and erosion of net worth.

Trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits.The static trade-off theory and the pecking order theory are two financial principles that help a company choose its capital structure.With the static trade-off theory, and since a company's debt payments are tax deductible and there is less risk involved in taking out debt over equity, debt financing is initially cheaper than equity financing. This means a company can lower its weighted average cost of capital (WACC) through a capital structure with debt over equity.The pecking order theory states that a company should prefer to finance itself first internally through retained earnings. If a company finances itself through debt, it is a signal that management is confident the company can meet its monthly obligations. If a company finances itself through issuing new stock, it is normally a negative signal, as the company thinks its stock is overvalued and it seeks to make money prior to its share price falling.

Empirical evidence which trade off theory fails to explain is that firms do not undo the impact of stock price shocks as they should under the basic trade-off theory and so the mechanical change in asset prices that makes up for most of the variation in capital structure