The Trade-off Theory of Corporate Capital Structure

Oxford Research Encyclopedia of Economics and Finance

65 Pages Posted: 11 Jun 2020 Last revised: 13 Jul 2021

See all articles by Hengjie Ai

Hengjie Ai

University of Minnesota - Twin Cities - Carlson School of Management

Murray Z. Frank

University of Minnesota; SAIF, Shanghai Jiao Tong University

Ali Sanati

American University

Date Written: August 31, 2020

Abstract

This paper provides a survey of the trade-off theory of corporate capital structure. First we provide an analysis of an equilibrium version of the theory. The firm raises debt from an investor. Debt provides interest tax shields but raises the probability of costly bankruptcy. The model provides closed form solutions for the quantity and price of debt. Second, we review dynamic trade-off theory based models. Third, we review the empirical evidence using the equilibrium model as the foundation. The literature has essentially resolved challenges to the theory based on the low leverage puzzle, profits-leverage puzzle, and speed of target adjustment. There is empirical support for predicted interest rate effects, and an impact of market conditions. There is evidence of tax effects in specific contexts, but the predicted tightly structured overall link between taxes and leverage remains challenging to identify. Overall, the theory provides a reasonable basis on which to build our understanding of capital structure. However, we identify several areas where significant theoretical and empirical work remains needed to improve our understanding.

Suggested Citation

Ai, Hengjie and Frank, Murray Z. and Sanati, Ali, The Trade-off Theory of Corporate Capital Structure (August 31, 2020). Oxford Research Encyclopedia of Economics and Finance, Available at SSRN: https://ssrn.com/abstract=3595492 or http://dx.doi.org/10.2139/ssrn.3595492

Hengjie Ai

University of Minnesota - Twin Cities - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States

Murray Z. Frank

University of Minnesota ( email )

Carlson School of Management
321 19th Avenue South
Minneapolis, MN 55455
United States
612-625-5678 (Phone)

SAIF, Shanghai Jiao Tong University ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

Ali Sanati (Contact Author)

American University ( email )

4400 Massachusetts Avenue NW
Washington, DC 20816-8044
United States

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