Static Trade-off Theory and Target Capital Structure | CFA Level I Corporate Issuers

Today, we’ll dive into the static trade-off theory and explore its implications on a firm’s target capital structure. We’ll also discuss the costs of financial distress, which play a crucial role in this theory.

Static Trade-off Theory: Finding the Optimal Capital Structure

Building on the MM propositions we discussed earlier, the static trade-off theory suggests an optimal capital structure exists, balancing the tax shield and the cost of financial distress. In other words, the value of a levered firm equals the value of an unleveraged firm plus the tax shield minus the present value (PV) of the cost of financial distress. The firm’s value is maximized when the difference between the tax shield and the cost of financial distress is at its peak.

Visualizing the Static Trade-off Theory

To better grasp this concept, let’s plot the firm’s value against the degree of financial leverage:

• When debt is zero, this represents the value of an unleveraged firm, aligning with the MM proposition with no taxes.
• Factoring in the tax shield, the value of the firm constantly increases, reflecting the MM proposition with taxes, which maximizes the value at 100% debt.
• Subtracting the costs of financial distress, which rise as leverage increases, we arrive at the static trade-off theory. Here, the optimal capital structure represents the sweet spot that maximizes the firm’s value.

Cost of Capital Perspective

Examining the static trade-off theory from the cost of capital perspective, we can recall the following:

• MM proposition with no taxes: The cost of equity increases with leverage, offsetting the lower cost of debt, keeping the weighted average cost of capital (WACC) constant.
• MM proposition with taxes: The increase in the cost of equity is partially reduced by the tax shield, resulting in a downward sloping WACC curve.

In the static trade-off theory, the cost of debt increases with leverage due to the rising costs of financial distress, causing the WACC curve to exhibit a minimum point that corresponds to the optimal capital structure for the company.

Target Capital Structure: Striving for the Optimal

A firm’s target capital structure is the one managers use over time when deciding how to raise additional capital. Ideally, the target capital structure should match the optimal capital structure. In practice, however, the actual capital structure tends to fluctuate around the target due to factors like exploiting financing opportunities or market value fluctuations of stocks and bond prices.

Costs of Financial Distress: What Are They?

Costs of financial distress encompass not only the explicit costs of company default and bankruptcy but also the implicit costs stemming from stresses caused by lower earnings or losses. Financially distressed companies may lose customers, suppliers, and valuable employees. The probability of financial distress increases with the degree of leverage, as well as other factors like management quality and corporate governance structure.

Conclusion

In summary, the static trade-off theory recognizes the benefits of increased tax shield with rising debt, but also acknowledges the increased costs of financial distress. Managers following this approach will seek to balance these factors and identify an optimal capital structure. Stay tuned for our next lesson, where we’ll delve into practical considerations when making capital structure decisions.