Question

Explain/discuss of the tradeoff theories for current accounts (e.g., cash, inventory, accounts receivable, accounts payable)

Answer 1

The 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 classical version of the hypothesis goes back to Kraus and Litzenberger[1] who considered a balance between the dead-weight costs of bankruptcy and the tax saving benefits of debt. Often agency costs are also included in the balance. This theory is often set up as a competitor theory to the pecking order theory of capital structure. A review of the literature is provided by Frank and Goyal.[2]

An important purpose of the theory is to explain the fact that corporations usually are financed partly with debt and partly with equity. It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder infighting, etc.). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.

The basic concept behind the static trade-off theory is to minimize the cost of capital by employing an

appropriate debt and equity financing. Firms are partly financed by debt and equity and the main benefit of debt

financing is the tax benefit of that debt, while on the other hand, the disadvantage of debt financing is debt cost

i.e. the interest or return which company pays on debt which is referred as bankruptcy cost. The static tradeoff

theory of capital structure states that in order to maintain the balance between the pros and cons of debt and

equity financing, the firm must choose the mixed type of financing. Moreover, the cost of capital cannot be

minimized by increasing the debt level because at a specific point, the cost of debt will become more expensive

than the cost of equity because it increases the Leverage level and due to which the risk of creditor increase

because of which their required rate of return increases. Furthermore, the increased amount of debt also makes

the investors and shareholders' financial position more risky. Hence, up to a certain limit, the cost of capital can

be decreased by increasing debt. However, after that limit, the cost of capital will start increasing. Therefore,

firms usually use the mixture of debt financing and equity financing in order to minimize the average cost of

capital and to increase the market value per share.

The static tradeoff theory of capital structure of firms varies from sector to sector. Industries, whose firms are

more tangible tend to borrow more rather using the equity because assets of these industries are collateral and

considered relatively safe. By using trade off theory, Rajan & Zingales (1995) concluded that there is a positive

correlation between Leverage, and profitability of a firm, whereas tangibility of assets and the size of the firm

found positively correlated with firm’s Leverage.

Under static trade off theory, de Mesquita & Lara conducted a research and concluded that the debt of the firm

and Leverage was positively correlated in the short run whereas, their correlation was found inverse in the long

run. Antonious, Guney, & Paudyal (2002) further validates the results of due Mesquita & Lara and concluded

that firm size is positively correlated with Leverage ratio. The tangibility of assets was found positive in those

countries where lending from banks was significant. Um (2001) argued that high profitability results in a higher

debt capacity of the firm and hence, a firm can have more tax shield. Therefore, according to the static tradeoff

theory there exist a positive relationship between profitability of a firm and financial Leverage.

Firms having more tangible assets will likely provide more collateral for debts. In the case of default, the assets

of the company will be seized however; the company will be safe from bankruptcy. Moreover, firms having a

large amount of tangible assets are less likely to default and will acquire more debt.

Accounts payable

It is the aggregate amount of an entity's short-term obligations to pay suppliers for products and services which the entity purchased on credit. If accounts payable are not paid within the payment terms agreed to with the supplier, the payables are considered to be in default, which may trigger a penalty or interest payment, or the revocation or curtailment of additional credit from the supplier.

When individual accounts payable are recorded, this may be done in a payables sub ledger, thereby keeping a large number of individual transactions from cluttering up the general ledger. Alternatively, if there are few payables, they may be recorded directly in the general ledger. Accounts payable appears within the current liability section of an entity's balance sheet.

Accounts payable are considered a source of cash, since they represent funds being borrowed from suppliers. When accounts payable are paid, this is a use of cash. Given these cash flow considerations, suppliers have a natural inclination to push for shorter payment terms, while creditors want to lengthen the payment terms.

From a management perspective, it is of some importance to have accurate accounts payable records, so that suppliers are paid on time and liabilities are recorded in full and within the correct time periods. Otherwise, suppliers will be less inclined to grant credit, and the financial results of a business may be incorrect.

Other types of payables that are not considered accounts payable are wages payable and notes payable.

Accounts receivable

the seller's balance sheet. The total amount of accounts receivable allowed to an individual customer … Accounts receivable refers to short-term amounts due from buyers to a seller who have purchased … losses. Accounts receivable are commonly paired with the allowance for doubtful accounts (a contra … respond to the granting of credit by competitors. Accounts receivable is listed as a current asset on … Accounts receivable … account), in which is stored a reserve for bad debts. The combined balances in the accounts receivable …

Inventory

not be immediately ready for sale. Inventory items can fall into one of the following three … Inventory Accounting … retail environment where items are bought from suppliers in a state ready for sale. Inventory is … Inventory … classification includes items purchased and held for resale. In the case of services, inventory can … Inventory is an asset that is intended to be sold in the ordinary course of business. Inventory may … , inventory is typically broken down into three categories, which are: Raw materials. Includes materials …