Capital Structure Considerations

How do businesses benefit from using capital structure, optimal capital structure, debt and equity, and return on investment? Businesses have the opportunity to earn more return from their investments and their blend of debt and equity capital structure. This section gives examples of how these concepts are used.

Trade-Off Consideration

Trade-off considerations are important because they take into account the cost and benefits of raising capital through debt or equity.


LEARNING OBJECTIVE

  • Describe the balancing act between debt and equity for a company as described by the "trade-off" theory

KEY POINTS

    • An important purpose of the trade off theory is to explain the fact that corporations are usually financed partly with debt and partly with equity. It states that there is an advantage to financing with debt.
    • The marginal benefit of further increases in debt declines as debt increases while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.
    • One would think that firms would use much more debt than they do in reality. The reason they do not is because of the risk of bankruptcy and the volatility that can be found in credit markets - especially when a firm tries to take on too much debt.

TERMS

  • trade-off

    Refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits.

  • trade credit

    a form of debt offered from one business to another with which it transacts


Trade-Off Consideration

The trade-off theory of capital structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. It is often set up as a competitor theory to the pecking order theory of capital structure. An important purpose of the theory is to explain the fact that corporations are usually financed partly with debt and partly with equity. It states that there is an advantage to financing with debt - the tax benefits of debt, and there is a cost of financing with debt - the cost of financial distress including bankruptcy.

Trade-off considerations are important factors in deciding appropriate capital structure for a firm since they weigh the cost and benefits of extra capital through debt vs. equity.

The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases. Of course, using equity is initially more expensive than debt because it is ineligible for the same tax savings, but becomes more favorable in comparison to higher levels of debt because it does not carry the same financial risk. Therefore, a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.

Another trade-off consideration to take into account is that the while interest payments can be written off, dividends on equity that the firm issues usually cannot. Combine that with the fact that issuing new equity is often seen as a negative signal by market investors, which can decrease value and returns.

As more capital is raised and marginal costs increase, the firm must find a fine balance in whether it uses debt or equity after internal financing when raising new capital. Therefore, one would think that firms would use much more debt than they do in reality. The reason they do not is because of the risk of bankruptcy and the volatility that can be found in credit markets -  especially when a firm tries to take on too much debt. Therefore, trade off considerations change from firm to firm as they impact capital structure.