A company's capital structure defines the mix of equity and debt finance used to finance its activities. For every company, the capital structure will differ based on its needs and usage. This combination of equity and debt finance may also vary during a period or from one year to another. A company’s capital structure is a crucial part of its financial position.
Deciding on a capital structure to use for a company is a strategic-level decision. Companies consider various factors when choosing the right mix of equity and debt finance to use in their operations. There are several approaches or theories that can help them in this decision-making. One of these is the static trade-off theory.
What is the Static Trade-Off Theory?
The static trade-off theory is relevant for capital structure. This theory focuses on finding a balance between equity and debt finance that companies use. The static trade-off theory balances both types of finance by establishing a point where the combined benefits from both are at a maximum. Similarly, it tries to minimize the costs related to using each type of finance.
Static trade-off theory comes from the 1950s based on the works of Modigliani and Miller. However, it is a theory that opposes their work rather than supporting it. Modigliani and Miller studied the capital structure theory and proposed capital structure irrelevance, in which they stated that a company’s capital structure is irrelevant for its value.
However, the static trade-off theory opposed that view by proposing an optimal point for capital structure. At this proposed point, this theory believes that the capital structure costs will be the lowest while also maximizing the benefits. The static trade-off theory also relates to the Weighted Average Cost of Capital (WACC).
How does the Static Trade-Off Theory work?
The static trade-off theory bases its view on the capital structure irrelevance theory from Modigliani and Miller. However, it opposes one of the assumptions made by the theory. The capital irrelevance theory assumes that there are no costs to financial distress when companies borrow finance. By removing this assumption, the static trade-off theory allows companies to establish an optimal capital structure point.
The statistic trade-off theory suggests that a company's debt finance is initially cheaper. It is because debt is tax-deductible and involves lesser risks for a company compared to equity. Therefore, a company can, in theory, decrease its weighted average cost of capital by accumulating debt finance. Theoretically, having a capital structure financed fully by debt finance will be much cheaper than an equity-financed capital structure.
However, debt finance comes with diminishing returns. The more debt a company accumulates, the higher its risks will be. At a specific point, the risks will exceed the benefits that companies get from this finance source. Companies would want to avoid reaching a point where the costs of debt finance exceed their benefits.
The static trade-off theory aims to identify the point at which debt finance has the maximum benefits. In short, this theory tries to identify the mix of equity and debt finance, where decreasing WACC and increasing financial risk offset each other.
Conclusion
A company’s capital structure refers to the combination of equity and debt finance it uses for its operations. Managing the capital structure is crucial for companies. There are several theories that help companies establish an optimal capital structure. One of these is the static trade-off theory. This theory seeks to find a point at which the benefits from the capital structure at a maximum.
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