One of the main assumptions in the Modigliani and Miller (1958) is that there are no taxes. The trade-off theory is a development of the MM theorem but taking in consideration the effects of taxes and bankruptcy costs. This theory is considered as the first step for the development of many other theories which have studied how firms choose their capital structure. Modigliani and Miller’s (1958) theory can be used to describe how firms use taxation to manipulate profitability and to choose an optimum debt level. Debt level at the other side increases the risk of bankruptcy or as we call it the bankruptcy costs because as the debt to equity ratio increases the debt holders will require higher interest rates but also the shareholders will pretend higher profits for their investments. (Brealey and Myers, 2003, p. 508-509) According to Brealey and Myers (2003) financial managers often think of the firm’s debt-equity decision as a trade-off between interest tax shields and the costs of financial distress. “Companies with safe, tangible assets and plenty of taxable income to shield ought to have high target ratios. Unprofitable companies with risky, intangible assets ought to rely primarily on equity financing. If there were no costs of adjusting capital structure, then each firm should always be at its target debt ratio” (Brealey and Myers, 2003) The value of the firm can be calculated with the formula:
V = D+E=VF+PV-PV
VF =i corporate value with all-equity financing,
PV= interest tax shields (the present value of future taxes saved because of the tax deductions for interest rates)
PV= costs of financial distress (the present value of future costs due to the default risk with higher leverage)
According to the trade-off theory, the manager should choose the debt ratio that maximizes firm value (Brealey and Myers, 2003, p. 498). So according to the trade-off theory, companies’ capital structure decisions point towards a target debt ratio, where debt tax shields are maximized and bankruptcy costs associated with the debt are minimized. According to Myers (2001) debt offersfirm a tax shield. The advantage is because the interest of debt is deductible before paying taxes Modigliani and Miller (1963). “This means, among other things, that the tax advantages of debt financing are somewhat greater than we originally suggested” (Modigliani and Miller, 1963, p. 434).So firms increase the level of debt in order to gain the maximum tax benefit but at the other side they increase the risk of a possible bankruptcy. According to the static trade-off hypothesis, a firm’s performance affects its target debt ratio, which in turn is reflected in the firm’s choice of securities issued and its observed debt ratios (Hovakimian et al., 2001). The standard presentation of static trade-off theory is provided by Bradley et al. (1984).
They made the following conclusion based on their static trade-off model:
1. An increase in the costs of financial distress reduces the optimal debt level.
2. An increase in non-debt tax shields reduces the optimal debt level.
3. An increase in the personal tax rate on equity increases the optimal debt level.
4. At the optimal capital structure, an increase in the marginal bondholder tax rate decreases the optimal level of debt.
5. The effect of risk is ambiguous, even if uncertainty is assumed to be normally distributed. The relationship between debt and volatility is negative. This theory has been both criticized and supported focusing on the fact that
this theory is based on the assumption of perfect knowledge in a perfect market (Myers, 1984). Also the theory predicts that highly profitable firms will have higher debt levels in order to maximize taxation benefits and increase the availability of capital. Different studies have been developed to prove if the companies in reality follow the trade of theory (Sogorb and López, 2003; Hackbarth, Hennessy and Leland, 2007; Serrasqueiro and Nunes, 2010).
Static Trade-off theory
The static trade off theory of optimal capital structure assumes that firms balance the marginal present values of interest tax shields against the costs of financial distress. (Shyam, Sunder and Myers,1999).The optimal level is when the marginal value of the benefits associated with debt issues exactly offsets the increase in the present value of the costs associated with issuing more debt (Myers, 2001). The benefits of debt are the tax deductibility of interest payments which favors the use of debt but the positive effect can be complicated by the existence of personal taxes (Miller, 1977) and non-debt tax shields (De Angelo and Masulis, 1980). De Angelo and Masulis (1980) study proposed a theoretical optimum level of debt for a firm, where the present value of tax savings due to further borrowing is just offset by increases in the present value of costs of distress. Also this theory assumes there are no transaction costs to issuing or repurchasing securities (Dudley, 2007). This theory also suggests that higher profitable firms have higher target debt ratio, because they would ensure higher tax savings from debt (Niu, 2008, p. 134), lower probability of bankruptcy and higher over-investment and these require a higher target debt ratio.
Dynamic Trade Off Theory
According to the static trade off theory the companies balance the tax benefits of debt with the risks of bankruptcy. But according to dynamic trade off theory it is costly to issue and repurchase debt in order to achieve the target debt ratio that would achieve the maximization of firm value. So Firms whose leverage ratios is not exactly as their target one, will adjust their capital structure when the benefits of doing so outweigh the costs of adjustment (Dudley, 2007). Dynamic trade off theory suggests that firms let their leverage ratios vary within an optimal range (Dudley, 2007). Hovakimian et al. (2001) found that more profitable firms are more likely to issue debt over equity. Empirical evidence of Dudley (2007) study supports the predictions of dynamic trade off theory, concluding that volatility increases the optimal leverage range and profitability and interest rates reduce the leverage range. He took data from COMPUSTAT for US companies with from 1994 to 2004 with a total of 25,102 firm year observations and undertook a two stage estimation procedure. According to Dudley (2007) study profitable firms find it advantageous to readjust their debt ratios more often in order to capture the tax benefits of debt as predicted by the dynamic trade off theory.
Empirical Evidence of Tradeoff theory
Sogorb and López (2003) used a sample of 6482 Spanish SMEs during the five-year period 1994–1998.Using panel data methodology, they found evidence that SMEs attempt to achieve a target or optimum leverage (like that suggested by the trade-off model) which is explained as a function of some specific characteristics of the firm, and they found less support for the view that SMEs adjust their leverage level according to their financing requirements (pecking order model). Also according to their study the coefficient of the effective tax rate is positive and statistically significant, so if SMEs have to pay more taxes they should increase the use of debt to reduce tax bills, but there are other costs like depreciation which are considered non-debt tax shields that reduces the importance of the fiscal advantage of debt. According to Hackbarth, Hennessy and Leland (2007) the trade-off theory is sufficient to explain many facts regarding corporate debt structure. They studied the optimal mixture and priority structure of bank and market debt using a trade-off model in which banks have the unique ability to renegotiate outside formal bankruptcy.
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