What is the trade off theory and how can it be used to choose an optimal capital

Question

What is the trade off theory and how can it be used to choose an optimal capital structure?

What M&M assumption allows us to not consider incentive conflicts between equity and debtholders in choosing investment and payout decisions?

What are the three common types of conflicts between debt and equity and how do they affect firm value? Does “cashing out” always affect firm value?

Why is the payout to equity convex when the firm uses leverage? Why is the payout to debt concave? How does leverage affect the equityholder’s incentive to take on risk? Why? How does debt respond to these incentives when determining the interest rate to charge?

Why might equity want to pay a dividend, which results in unlevering, even when they are near bankruptcy?

Explanation / Answer

Trade-off theory looks at the compromises to be reached between debt and equity in deciding an optimal capital structure. Equity is costlier but does not increase the riskiness of cash flows, since it does not require periodic servicing nor does it have a fixed repayment date. Debt is cheaper but increases the variability of the cash flows since the revenues and costs and the risks associated with get amplified due to the increased capital allocation. Further interests have to be repaid periodical and the debt has a fixed maturity. These claims have precedence over equity and hence reduce the net profit. This also increases the bankruptcy risk in case the cash flows are insufficient to service the debt. Debt, however, has a tax benefit associated with it since interest is tax deductible.

Perfect information and full rationality (efficient markets) are the assumptions that allow us to consider incentive conflicts between equity and debt holders. With full information about future cashflows, equity holders try to maximize leverage since it increases the equity value. This is because equity can be considered a call option on the assets. Hence when the variability increases, this option increases in value. Debt holders are wary of letting leverage go out of control because they have written put option on the assets. Hence if the possibility of large negative earnings increases, their pay-offs suffer. So they prefer less leverage.

Conflicts between equity and debt holders include:

Cashing out or paying off debt holders should ideally have no impact on the firm value since the discount rate on future cash flows increases to offset the decrease in interest payments and the tax shield.

Payout is convex with leverage for equity because the value of the call option on the assets increases with the variability of incomes up to a point but decreases as the likelihood of a bankruptcy increases to a very high level in which case the call option begins to have a consistently zero value. Similarly, the debt holders have written a put option on the assets and hence their pay-offs decreases with leverage up to a point after which the likelihood of a default becomes very high and the put option value becomes zero with a high probability.

First four sub questions answered per chegg policy. post the rest separately.

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