The Trade-off Theory of Corporate Capital Structure

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.