Trade-off Theory

The Trade-Off Theory relaxes the Modigliani-Miller theory, by stating the following:

  • Taxes matter because interest payments are tax-deductible (a benefit of debt)
  • There are costs associated with carrying too much debt (e.g. potential bankruptcy/default)

Thus, optimal leverage trades off the benefits (e.g. tax shield) and its costs (e.g. financial distress)

Benefits of debt

  • Tax shield – Interest on debt is tax-deductible, resulting in incremental cash flow to the firm

Costs of debt- Financial distress

  • Workout – Informal reorganization
  • Chapter 11 – Formal reorganization
    • Goal is to keep the firm a going concern
    • Firm remains in control of operations
    • Existing financial claims often replaced with new ones
  • Chapter 7 – liquidation
    • Termination of firm as going concern
    • Firm sells all of its assets, and then distributes the proceeds to its creditor