Trade off Theory

The preceding arguments led to the development of what is called “the trade-off theory of leverage,” in which firms trade off the benefits of debt financing (favor-able corporate tax treatment) against the higher interest rates and bankruptcy costs. A summary of the trade-off theory is expressed graphically in Figure 13-10. Here are some observations about the figure:

1. The fact that interest is a deductible expense makes debt less expensive than common or preferred stock. In effect, the government pays part of the cost of debt capital, or to put it another way, debt provides tax shelter benefits. As a result, using debt causes more of the firm’s operating income (EBIT) to flow through to investors, so the more debt a company uses, the higher its value and stock price. Under the assumptions of the Modigliani-Miller with-taxes paper, a firm’s stock price will be maximized if it uses virtually 100 percent debt, and the line labeled “MM Result Incorporating the Effects of Corporate Taxation” in Figure 13-10 expresses their idea of the relationship between stock prices and debt.

2. In the real world firms rarely use 100 percent debt. One reason is the fact that stocks benefit from the lower capital gains tax. More importantly, firm’s limit their use of debt to hold down bankruptcy-related costs.

3. There is some threshold level of debt, labeled D₁ in Figure 13-10, below which the probability of bankruptcy is so low as to be immaterial. Beyond D₁, how-ever, bankruptcy-related costs become increasingly important, and they reduce the tax benefits of debt at an increasing rate. In the range from D₁ to D₂ bankruptcy-related costs reduce but do not completely offset the tax benefits of debt, so the firm’s stock price rises (but at a decreasing rate) as its debt ratio increases. However, beyond D₂, bankruptcy-related costs exceed the tax benefits, so from this point of increasing the debt ratio lowers the value of the stock. Therefore, D₂ is the optimal capital structure. Of course, D₁ and D₂ vary from firm to firm, depending on their business risk and bankruptcy costs.

4. While theoretical and empirical work supports the general shape of the curves in Figures 13-8 and 13-10, these graphs must be taken as approximations, not as precisely defined function. The numbers in Figure 13-8 are shown out to two decimal places, but that is merely for illustrative purposes the numbers are not nearly that accurate in view of the fact that the data on which the graph is based are judgmental estimates.

5. Another disturbing aspect of capital structure theory as expressed in Figure 13-10 is the fact that many large, successful firms, such as Intel and Microsoft use far less debt than the theory suggests. This point led to the development of signaling theory, which is discussed below.