The Trade-off Theory: Cost of Financial Distress and Agency Costs
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 Trade-Off Theory of Capital Structure is a theory in the realm of Financial Economics about the corporate finance choices of corporations. Its purpose is to explain the fact that firms or corporations usually are financed partly with debt and partly with equity. It states that there is an advantage to financing with debt, the tax benefit of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder infighting, etc.). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases so that a firm that is optimising its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Although the empirical success of the alternative theories is often dismal, the relevance of this theory has often been questioned. For example, Miller’s (1977) metaphor speaks of the balance between those two as equivalent to the balance between horse and rabbit content in a stew of one horse and one rabbit. Other critics have suggested it is the mechanical change in asset prices that makes up for most of the variation in capital structure. Recognise that costs of financial distress and agency costs are real.
Financial distress costs (includes bankruptcy)
1. Direct costs
Lawyer’s fees, court costs, administrative expenses, assets disappear or become obsolete
2. Indirect costs
Managers make short-run decisions; customers and suppliers may impose costs
More debt is likely to be experienced. Distress stockholders (thus management) want to risk, while bondholders do not. Use covenants to align interests costs: monitoring to ensure they are followed; also may hamper business. In essence, lost efficiency and monitoring costs reduce the advantage of debt, given agency costs and financial distress.
VL = VU + TD – (PV of expected costs of financial distress) – (PV of agency costs)
Consequences of Financial Distress
Specific bankruptcy costs include legal and administrative costs along with the sale of assets at ‘distress’ prices to meet creditor claims. Lenders build into their required interest rate the expected costs of bankruptcy, which reduces the market value of equity by a corresponding amount.
1. Investing in risky projects
2. Reluctance to undertake profitable projects
3. Premature liquidation
4. Short-term orientation