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Companies must decide how to fund their numerous initiatives and activities, as well as how to pay staff and keep the lights on as they develop and continue to function.

While sales revenues are important sources of income, most businesses also seek financing from investors or lenders. But what is the appropriate balance of equity shares offered to investors and bonds issued to creditors? The capital structure theory examines this critical business subject.

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Background of Trade-off Theory

The trade-off theory of capital structure holds that a firm decides how much debt and how much equity to utilize by weighing the costs and advantages. The traditional form of the concept may be traced back to Kraus and Litzenberger, who analyzed a trade-off between the deadweight costs of bankruptcy and the tax-saving advantages of debt. Frequently, agency charges are included in the balance. This hypothesis is frequently presented as a rival theory to the pecking order theory of capital structure. Ai, Frank, and Sanati present an assessment of the trade-off theory and its supporting evidence.

What was the Purpose Behind its Development?

Summing up our Trade-off Theory assignment help, one essential goal of the theory is to explain why firms are often financed in part with debt and partly with equity. It states that there is an advantage to financing with debt, the tax benefits of debt, and there is a cost to financing with debt, the costs of financial distress, including debt bankruptcy costs and non-bankruptcy costs. The marginal benefit of more debt grows as debt increases, but the marginal cost increases, therefore a company that wants to maximize its total value would consider this trade-off when deciding how much debt and equity to utilize for financing.

The Net Income Approach

David Durand, an economist who advocated for financial leverage, proposed this idea in 1952. He hypothesized that changes in financial leverage led to changes in capital costs. In other words, when the debt ratio rises, so does the capital structure, and the weighted average cost of capital (WACC), resulting in higher company value.


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In the absence of taxes, the Net Operating Income Approach, also introduced by Durand, is the inverse of the Net Income Approach. WACC remains constant in this technique. It holds that the market evaluates the entire business, and any discount has no bearing on the debt-to-equity ratio. If tax information is supplied, it indicates that WACC decreases as debt financing increases, and a company's worth will rise.

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