Trade-off theory of capital structure

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.

[2] A review of the trade-off theory and its supporting evidence is provided by Ai, Frank, and Sanati.

[4] Taxes are large and they are sure, while bankruptcy is rare and, according to Miller, it has low dead-weight costs.

Accordingly, he suggested that if the trade-off theory were true, then firms ought to have much higher debt levels than we observe in reality.

Myers was a particularly fierce critic in his Presidential address to the American Finance Association meetings in which he proposed what he called "the pecking order theory".

As the debt equity ratio (i.e. leverage ) increases, there is a trade-off between the interest tax shield and bankruptcy , causing an optimum capital structure, D/E*. The top curve shows the tax shield gains of debt financing, while the bottom curve includes that minus the costs of bankruptcy.