Literature Review on Trade-off Theory

A decision maker running a firm evaluates the various costs and benefits of alternative leverage plans. Kraus and Litzenberger (1973) provide a classic statement of the theory that optimal leverage reflects a tradeoff between the tax benefits of debt and the deadweight costs of bankruptcy.

 In complete and perfect capital markets the firm’s market value is independent of its capital structure. The taxation of corporate profits and the existence of bankruptcy penalties are market imperfections that are central to a positive theory of the effect of leverage on the firm’s market value. Kraus and Litzenberger (1973) formally introduce the tax advantage of debt and bankruptcy penalties into a state preference framework. The market value of a levered firm is shown to equal to unlevered market value, plus the corporate tax rate times the market value of the firm’s debt, less the complement of the corporate tax rate times the present value of bankruptcy costs. 

Kraus and Litzenberger (1973) concluded that contrary to the traditional net income approach to valuation, if the firms’ debt obligation exceeds its earnings in some states the firm’s market value is not necessarily a concave function of its debt obligation.

According to Myres (1984), a firm that follows the trade off theory sets a target debt to value ratio and then gradually moves towards the target. The target is determined by balancing debt tax shields against cost of bankruptcy. A firm’s optimal debt ratio is usually viewed as determined by a tradeoff of the costs and benefits of borrowing, holding the firm’s assets and investment plans constant. The firm is portrayed as balancing the value of interest tax shields against various cost of bankruptcy. It is important to calculate value of tax shields and costs of bankruptcy, but these disagreements give only variations on a theme. The firm is supposed to substitute debt for equity, or equity for debt, until the value of the firm is maximized. So objective is to maximize value of firm for which various options may be used depending where advantage is available to the firm. If there were no costs of adjustment, and the static tradeoff theories correct, then each firm’s observed debt to value ratio should be its optimal ratio.  However, there must be costs. Large adjustment costs could possibly explain the observed wide variation in actual debt ratios, since firms would be forced into long excursions away from their optimal ratios. 

According to Myres (1984) if adjustment costs are small, and firms stay near their target debt ratios, it is difficult to understand the observed diversity of capital structures across firms that seem similar in a static tradeoff framework. However if adjustment costs are large, so that some firms take extended excursions away form their targets, and then we ought to give less attention to refining our static tradeoff stories and relatively more to understanding what the adjustment costs are.

 The tradeoff theory justifies moderate debt ratios. It says that the firm will borrow up to the point where the marginal value of tax shields on additional debt is just offset by the increase in the present value of possible costs of financial distress Myres (2001). Cost of financial distress include the legal and administrative costs of bankruptcy, as well as the subtle agency, moral hazard, monitoring and contracting costs which can erode firm value even in formal default is avoided. Myres (2001) argued that tradeoff theory is in trouble on the tax front, because it seems to rule out conservative debt ratios by taxpaying firms.

According to Myres (2001) if the theory is right, a value maximizing firm should never pass up interest tax shields when the probability of financial distress is remotely low. Yet there are many reputable, profitable companies with better credit ratings operating for years at low debt ratios. Myres (2001) referred Wald who found that profitability was the single largest determinant of debt asset ratios in cross sectional tests for the United States, United Kingdom, Germany, France and Japan. High profits mean low debt, and vice versa.

But it is also argued that if managers can take advantage of valuable interest tax shields, as the tradeoff theory predicts, we should observe exactly the opposite relationship. High profitability means that the firm has more taxable income to shield, and that the firm can service more debt without risking financial distress. The tradeoff theory cannot account for the correlation between high profitability and low debt ratios.

In a dynamic model, the correct financing decision normally depends on the financing margin that the firm anticipates in the next period. Some firms expect to pay out funds in the next period, while others expect to raise funds. If funds are to be raised, they may take the form of debt or equity. However generally a firm considers a combination of these actions

(Frank and Goyal, 2005). 

 Frank and  Goyal (2005)  illustrate this concept with the help of two examples. First suppose a firm is very profitable so instead of raising funds, it may plan to give dividend to shareholders. Firm can decide to distribute it today, or it can hold onto the funds for one more period and then distribute them next period. Now which policy firm should adopt is depending on the tax rates and on rates of return that the firm can earn relative to the returns that the shareholders can obtain directly. If firm have much better investment opportunities than do the shareholders. Then it may be better for the firm to hold onto the funds even if it has a higher tax rate than the shareholders have. So we can conclude that more profitable firms should retain more earnings than should less profitable firms. Therefore we can conclude that more profitable firms have lower leverage.

In the second example suppose a firm has more money today than it require investing today, firm is forecasting that they will need money in a year or two. In a tax free world, the firm could pay out the excess money to shareholders today. When they will need this fund again after some time, the firm could raise new equity. But taxes create a wedge.  When firm decided to pay money to shareholders, now shareholders have to pay taxes. With taxes, such financing round trips can be expensive. Therefore, distributing funds and then raising new equity subsequently imposes a tax liability on shareholders that could have been avoided had the firm retained the funds. Hence, taxes can directly motivate firms to retain earnings.

Frank and Goyal (2005) referred in their paper that Stiglitz examined the effects of taxation from a public finance perspective and assumed away uncertainty. His analysis highlights an interesting asymmetry in the tax code. Money paid in to the firm is not taxed, but money paid out is taxed. His basic result is that it pays to finance as much investment as possible through retained earnings and the excess of investment over retained earning with debt. The observed leverage ratio is thus a fortuitous outcome of the profit and investment history of the firm. Thus dynamic models contain feature that seem to allow the trade off theory to provide a much better account of how firms finance their operations than had been thought.

Kane et al. (1984) developed a valuation model for a leverage  firm with bankruptcy costs, incorporating personal taxes, and observed that differences across firms in bankruptcy costs alone cannot account for the simultaneous existence of leverage and unlevered firms. Next applied simulation analysis and concluded that the tax advantage to debt is small and the bankruptcy cost/tax advantage model provides little insight into the determination of capital structure.

The solution of model suggests that the advantage of debt finance is best measured as a rate of return per period. Simulation results indicate that the advantage of debt measured in this way is quite small for reasonable parameters. The personal tax rate must be extremely close to the corporate rate in order to explain the existence of unlevered firms and at those rates, the annual rate of return advantage to debt is small.  Kane et al. (1984) concluded that the tax advantage/bankruptcy cost tradeoff is unlikely to play a major role in explaining observed leverage patterns. So if a firm wants to optimize its overall value it will mainly focus on three factors i.e.; taxes, bankruptcy costs and agency costs. Firm must have a trade-off between these factors.