The trade-off theory is a capital structure theory. Like other capital structure theories, the trade-off theory presents a model of how a company should arrange its finances to optimize profitability and grow the business. The specifics of the trade-off theory focus on balancing investment between debt and equity for the benefit of investors and the company as a whole. Bonds feature prominently in the trade-off theory because they are a primary form of debt financing.
The trade-off theory suggests maintaining a capital structure that relies on taking advantage of the tax benefits of debt. Capital structure refers to the way in which a company finances operations through outside investment, and incorporates equity, bonds and other securities. Basically, the trade-off theory suggests that companies issue debt as a means of collecting tax breaks. These tax breaks theoretically provide companies with extra money to give back to investors as investment incentive. Some of this money is also reinvested in the company's operating capital.
Balancing Debt and Equity
Equity and debt constitute the two primary facets of the capital structure under the trade-off theory. As per the theory, companies must delicately balance debt and equity as a means of financing. Issuing too much debt puts a company in danger of bankruptcy, at least on paper if not in reality. A company with too much debt risks devaluing its own stock and therefore ruining its capital structure. However, not issuing enough debt inhibits the flow of capital by not allowing a company to take advantage of the tax benefits offered on debt interest levels. The correct balance for a company depends upon a number of variables, including size, budget and particular industry.
Bonds in the Trade-Off Theory
Bonds constitute one of the most important facets of the trade-off theory. As a primary form of debt for many companies, bonds issued bring capital into the company while also allowing the advantage of special tax privileges. Companies create bonds as loans and sell them on a securities market. Each bond -- all of them small parts of a larger loan -- constitutes a form of debt because the company owes money to the investors who own the bonds. In a literal sense, the trade-off theory suggests issuing a balance of bonds and stocks as a means of generating capital and accruing tax benefits, while not issuing so many bonds as to provoke fears of bankruptcy.
Trade-Off Theory vs. Other Theories
Various other capital structure theories exist. The pecking order theory creates a hierarchy of financing methods which begins with reinvesting capital in the company and selling short-term assets, followed by issuing debt, issuing preferred stock and, as a last resort, issuing common stock. Pecking order differs significantly from trade-off theory because it eschews the notion of relying on investors for capital, and places a higher emphasis on debt than stock. The Modigliani-Miller (MM) theory suggests using nothing but debt to finance a company. This theory gave rise to bankruptcy concerns, which precipitated the creation of the trade-off theory.
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