Trade off theory

Miller (1977) provides the second key capital structure theory, trade-off theory. Trade

off theory focuses on achieving the perfect balance between maximising the tax shield,

and minimising the financial distress costs. Trade-off theory incorporates corporate and

personal tax into their model, unlike M&M who exclude personal taxation from both of

their models. Trade-off theory is developed through companies trying to achieve the

correct allocation of debt and equity in their capital structure, to ensure the optimal

capital structure can be achieved. The aim of all companies is to achieve the optimal

capital structure, to ensure the benefits of debt are maximised, without risking financial

distress (DeAngelo and Masulis, 1980). The second assumption that is built into this

statement is the company’s profits are high enough to benefit from the tax shield, this is

called tax exhaustion. The optimal debt ratio is found as a tradeoff between the costs and

the benefits of borrowing, all else remaining constant to ensure the benefits of the tax

shields can be achieved without risking financial distress. One issue with the tax shield is

the assumption that all companies will receive the same marginal tax rate; this is rarely

the case and does further complicate the advantages of debt. There are other variables to

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(DeAngelo and Masulis, 1980). One key benefit of companies taking out debt, is they are

able to benefit from the tax shield; the size of the gain does differ between companies.

The trade-off theory (Miller, 1977) explains why in reality debt ratios vary between

different industries; for example retailers will have a high debt level due to the tangible

nature of their safe assets. High growth technology companies that have intangible

assets, which are inherently riskier, will therefore have lower debt levels.

Restructuring is the process which companies undergo to change their capital structure

due to exceeding their target debt level, without changing their real assets, which remain

the same. For example, issuing a rights issue in order to replace a percentage of debt, the

number of shares in issue increases, while their assets remain the same.

The implication of trade-off theory in relation to leverage is the notion that companies

adjust their leverage levels to a target, deviations from the target are slowly eliminated

(Frank and Goyal, 2009). The target adjustment can be viewed as a separate hypothesis

called static trade off theory; leverage is determined by taxes and bankruptcy in the static

model. The static trade-off theory indicates that companies determine the level of debt,

by balancing the advantages that the tax shield generates with the disadvantages of

financial distress. Research (Brounen et al., 2006) finds for the UK, Netherlands and

Germany, over two thirds of companies aim for a target debt ratio. Brounen’s study finds that bankruptcy costs are less important than the tax advantages, which are created

through the inclusion of debt in the capital structure. The selection of the types of capital

taken out in a company’s capital structure is found to not have a relationship with the attraction of specific investors (Rajan and Zingales, 1995). However, support is most

evident for the target adjustment hypothesis than for the static trade-off theory (Frank and

Goyal, 2009). One criticism of the static trade-off theory concerns how the tax shield

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only a century old; taxes do not provide justification of the use of debt in companies.

However, this does not imply that taxes should be ignored when considering the reasons

behind the choice of debt and equity in a company’s capital structure (Frank and Goyal, 2009). The rebalancing of a company’s capital structure is often prevented through transaction costs; however, Fischer et al. (1989) and Brounen et al. (2006) find

transaction costs to not be a key driver in a company’s debt policy. Recently, dynamic structural trade-off models have been developed (Hennessy and Whited, 2005; Leary and

Roberts, 2005), an advantage of these models is they are able to include many factors.

The UK operates a creditor oriented system which enforces a binding agreement between

a company and its creditors, the aim is to maximise the payment to creditors during

periods of insolvency and bankruptcy. The benefits of debt also present themselves in the

company’s cost of capital. As the level of debt increases in the company it lowers the WACC, whereby a point is reached in which companies achieve the minimum WACC,

and it starts to increase. The minimum WACC is also achieved when the share price is

maximised. Besley and Brigham (2005) find the optimal amount of debt and equity in

the company’s capital structure can be achieved through ensuring a balance between maximising the share price, and minimising the WACC.

The ability of debt to create a tax shield, and have a lower cost in comparison to equity,

encourages companies to borrow more debt than they are able to service, leading to

financial distress. Financial distress theory assumes that a company’s debt is free of risk,

this will hold true if the debt is small in relation to its total value (Gordon, 1971).

However, any non-payment of the monthly interest payments that is caused by a lack of

profits, or cashflow problems, increases the risk of financial distress. The result of a

company going into financial distress can have implications on the value of their equity

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shareholders, and existing debtholders is another variable in the financial distress theory

(Gordon, 1971). An efficient stock market will react to the information and revalue the

company, which could have further spiraling implications if information is inaccurate.

The existence of debt in a company’s capital structure has the advantages that the tax shield creates through the payment of interest; increasing the risk of companies becoming

susceptible to financial distress. Companies who are unable to pay their liabilities, or

make late payments face a higher liquidation and bankruptcy risk (Kraus and

Litzenberger, 1973). Market imperfections are created through the taxation of company

profits, and the costs of bankruptcy. The balance between maximising the tax savings at

the avoidance of bankruptcy is such a delicate balance that companies aspire to achieve

optimal leverage, to ensure the maximisation of the market value of the company (Kraus

and Litzenberger, 1973).

The optimal mix of debt and equity is impacted by financial distress costs, which are

evident in the real world; ignoring these costs could result in bankruptcy. Financial

distress costs are split into direct and indirect. Direct costs are associated with

bankruptcy proceedings, and include accountant and lawyer fees (Arnold, 2012). Indirect

costs are the losses that arise following bankruptcy; however, they are not expenses that

are spent on the process itself. For example, the loss of sales, loss of key employees, and

the constraints on future projects.

As companies increase their level of debt, the probability of financial distress increases;

advantages such as the tax shield increase as levels of debt rise. The balance between the

risk of bankruptcy, and the benefits achieved through taking out debt in the capital

structure is one that has to be carefully managed by companies. Optimal capital structure

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the expected loss from bankruptcy (Weston and Copeland, 1992). Robichek and Myers

(1966) state that there is a trade-off between ‘the present value of the tax rebate

associated with the marginal increase in leverage, and the present value of the marginal

cost of the disadvantages of leverage.’ Hirshleifer (1966) states that in perfect capital markets, after the inclusion of the tax benefits and bankruptcy penalties, an optimal

capital structure can exist. This enables the company’s cost of capital to be minimised,

and the company valuation to be maximised.

Trade-off theory (Miller, 1977) is a key theory in relation to this study, and could indicate

how a company’s decision in relation to the decision between debt and equity could be influenced by companies. In this study the dependent variable is measured using three

measures of debt; total debt, short term debt and long term debt. The purpose of using

several dependent variables allows the study to identify whether there are differences

apparent within the duration of the debt that is taken out.