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Static trade-off theory relation to agency theory of capital structure?

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Answered 2009-07-18 08:47:51

Trade-off theory of capital structure basically entails offsetting the costs of debt against the benefits of debt. MM 1963 introduced the tax benefit of debt. Later work led to a optimal capital structure which is given by the trade off thoery. The first element usually considered as the cost of debt is usually the financial distress costs or bankruptcy costs of debt. It is important to note that this includes the direct and indirect bankruptcy costs. Trade-off theory can also include the agency costs from agency theory as a cost of debt to explain why companies dont have 100% debt as expected from MM 1963. 95% of empirical papers in this area of study looks at the conflict between managers and shareholders. The others look at conflicts between debtholders and shareholders. Both are equally important to explain how the agency theory is related to the trade-off theory. The introduction of a dynamic trade-off theory makes the predictions of the this theory a lot more accurate and reflective of that in practise.

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