Question

Discuss the trade-off theory of capital structure. What empirical support is there for the theory? (maximum length guide: about 150 words)

Answer 1

Answer:

Capital structure- It is the mix of debt and equity in company's capital/funding.

Trade off theory of capital structure- This theory states that the optimal capital structure is a trade off between cost of financial distress and interest tax shields. This theory was invented by Modigliani and Miller in 1950. There are two propositions of this theory-

Proposition 1- This proposition says that capital structure is not relevant to the value of the firm. Value of two identical firms will remain same and will not be affected by alternatives to finance the asset. Value of firms depends on the expected future earnings when there is no tax.

Proposition 2- This proposition says that the financial leverage reduces the weighted average cost of capital and increases the value of firms.

Debt financing is cheaper than equity financing. Company can reduce its overall cost of capital by including more debt than equity in the capital structure. On the other hand, increased debt increases obligation and interest burden and also the risk.

In short, trade off theory tells that decreasing WACC offsets the financial risk for a company.