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TRADE-OFF THEORY - Coggle Diagram
TRADE-OFF THEORY
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Decision regarding how much Debt (or Financial Leverage) is based on Trade-off between the advantage and disadvantage of debt.
Advantage of Debt over Equity: interest payments are not taxed. Known as Interest Tax Saving or Tax Shield or Tax Shelter
Disadvantage of Too Much Debt: Firm becomes more Risky so Lenders and Banks Charge Higher Interest Rates and Greater Chance of Bankruptcy
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Interest paid is tax deductible, capital structure affects the after tax cash flows to the firm’s investors.
An important purpose of the theory is to explain the fact that corporations usually are financed partly with debt and partly with equity.
The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value
When 100% Equity firm adds a small amount of debt, the value of its stock goes up at first because Total Return Increase
Total Return = Net Income + Interest
But if the firm keeps adding too much debt then the chance of bankruptcy will offset the initial benefit and stock value will fall.
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A range for the Optimal Capital Structure or Debt/Equity Mix can be calculated in theory. This where the firm has Maximum Value and Minimum WACC. Practically speaking it varies across industries and companies.
Optimal D/E can range from 20/80 to 70/30 and keeps changing with time depending on the firm's financial health and growth strategy
MM theory ignores bankruptcy costs, which increase as more leverage is used
-At low leverage levels, tax benefits outweigh bankruptcy costs
-At high levels, bankruptcy costs outweigh tax benefits
-An optimal capital structure exists that balances these costs and benefits