The Main Theory behind the Trade off Model of Capital Structure
The idea about how much debt structure and how much equity structure can be used by a company to balance the benefits and costs of that particular company is referred to as tradeoff theory of capital structure. This theory basically tries to equalize benefits of debts with the cost of debt. It is this theory which helps a particular company takes important corporate decisions.
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Main concepts behind tradeoff theory
There are two main costs that this theory deals with – one is agency cost and the second is financial distress cost. This theory mainly explains that investments of corporates come partly from equity and partly from debt.
This theory also states different tax benefits of debts, the advantages of financing with debts and also bankruptcy and the non-bankruptcy cost of debts.
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This theory also includes the cost of the agency that is taken from the agency theory and also cost of debt. It also explains the fact as to why companies do not have 100% debt. Here you mainly get to know about the conflict that is there between shareholders and managers.
However other theories deal with the conflict between shareholders and debt holders. It is important to understand both these theories because it helps in explaining the relationship between tradeoff theory and agency theory.
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What does financial distress cost?
The financial distress cost is basically the cost that is involved in the insolvency of a particular company. When insolvency procedure starts than in the most cases company has to sell assets at a less price. This price is basically much lesser than the actual market value of these assets. There is also a huge amount of insolvency and administrative cost involved in this process.
In case a company is not insolvent then in such cases, there might be a lot of indirect costs involved like the cost of customers, suppliers, investors, managers and also cost of shareholders.
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