Question

central to he trade- off theory is;

a) obtaining the lowest WACC

b) maintain a high level of equity.

c) a lowest debt ratio.

d) maximize dividend payouts.

e) ability to issue tax exempt financing.

Answer 1

The trade-off theory suggests that the optimal capital structure is a trade-off between interest tax shields and cost of financial distress. Cost of financial distress includes the costs such as bankruptcy costs of debt and other non-bankruptcy costs such as staff leaving, suppliers/customers demanding unfavourable payment/credit terms, etc.

a) obtaining the lowest WACC : WACC refers to the weighted average cost of capital of the company. In other words, it is the cost of each of the source of financing (ordinary shares, preference shares, debts/bonds) weighted in propotion to thier share of the total capital. Trade off theory speaks about the propotion of debt finance and equity finance to use which will provide optimum balancing of costs and benefits which implies the lowest WACC. Thus, the central to trade off theory is obtaining the lowest WACC

b) maintain a high level of equity : Mainiaining a high level of equity results in lower debt and accordingly the lower interest tax shields. Also, high level of equity could also result in high dividends (depending on the agreement with shareholders and thier required return). Thus, this will adversely impact the WACC and may not result in optimum balacing of costs and benefits. Hence, maintain a high level of equity is NOT central to trade off theory.

c) a lowest debt ratio: Mainiaining a lowest debt ratio is same as maintain a high level of equity and hence lower debt ratio implies lower interest tax shields. Also, high level of equity could also result in high dividends (depending on the agreement with shareholders and their required return). Thus, this will adversely impact the WACC and may not result in optimum balacing of costs and benefits. Hence, a lowest debt ratio is NOT central to trade off theory.

d) maximise dividend payouts: Maximising dividend payouts will result in higher cost of equity of the company which will in turn adversely impact WACC and may not result in optimum balacing of costs and benefits. Hence, maximise dividend payouts is NOT central to trade off theory.

e) ability to issue tax exempt financing : Ability to issue tax exempt financing implies higher debt and debts usually comes at a higher cost than equity and the payment of annual coupons are fixed unlike dividends which need to be paid only when the company makes profits and depending on the shareholders agreement. Also, higher debt will also have higher financial distress costs. Thus, this may not result in optimum balacing of costs and benefits. Hence, ability to issue tax exempt financing is NOT central to trade off theory.