FREE online courses on Capital Structure of Firms - Capital Structure Theory - Lessons from the tradeoff models

 

What did we learn from the tradeoff models (i.e. the MM and Miller models adjusted for financial distress and agency costs)?

 

Higher-risk firms should borrow less because they face a higher probability of financial distress for the same level of debt compared to lower-risk firms.

Firms with tangible assets (such as buildings and machines) can use more debt compare to firms with intangible assets (such as patents). The reason for this is because tangible assets tend to retain a larger percentage of its value in the situation of a financial distress.

 

Firms facing higher tax rate should use more debt compare to firms facing lower tax rate. This is because higher tax rate means greater tax benefit for the same level of debt used.

 

Based on what we have learned from the various models, we know that firms should borrow up to the point where the benefits of using debt is completely offset by the increased cost of using debt. Unfortunately, empirical evidence does not completely support the validity of the results (or “lessons”) of the tradeoff models. For example, studies have shown that firms used the same level of debt financing before and after corporate taxes are levied and the level of debt financing fluctuates among similar firms. In other words, these studies point out that the tradeoff models captured part of a firm's financing behavior but not all of it. This means something must have been left out.