Hello, Dohyun Kim

The question you posed also came to my mind when I was responding to the pecking

order theory. So, I want to answer your question about different capital structure methods (like

Static trade-off theory)

The capital-structure irrelevance statement, developed by the economists Modigliani and

Miller in the 1950s after investigating capital structure theory, is the foundation of the static

trade-off theory (Modigliani & Miller, 1959). The M&M theorem made two propositions

(Ghosh, Cai & Fosberg, 2017):

 Proposition 1: The worth of two comparable enterprises would be the same, and how the

resources financed would not impact the value. When taxes are not present, a firm's value

is influenced by projected future profits.

 Proposition 2: Financial power raises a firm’s worth and lowers the weighted average

cost of capital when tax information is readily available.

The trade-off theory states that because debt payments can deduct tax for businesses, so initially,

debt financing is less costly than equity. Executing debt over equities carries less risk. This

suggests that a company lowers its WACC by adopting a capital structure that prioritizes debt

over equity. A firm's exposure to danger is also raised with higher debt, which partially offsets

the weighted average cost of capital reduction. Consequently, the trade-off theory identifies a

debt-to-equity ratio where a firm's growing financial risk is balanced by a dropping Weighted

average cost of capital (De Jong, Verbeek & Verwijmeren, 2011).

In short, the trade-off theory asserts that debt financing has benefits and emphasizes the cost

of bankruptcy and debt. At the same time, the pecking-order theory emphasizes employing
internal resources first and outside resources as the last choice for funding (Adair & Adaskou,

2015).

So, is the trade-off theory better or POT?

References

Modigliani, F., & Miller, M. H. (1959). The cost of capital, corporation finance, and the theory

of investment: Reply. The American Economic Review, 49(4), 655-669.

http://www.jstor.org/stable/1812919

Ghosh, A., Cai, F., & Fosberg, R. H. (2017). Capital structure and firm performance. Routledge.

https://doi.org/10.4324/9781315081793

De Jong, A., Verbeek, M., & Verwijmeren, P. (2011). Firms’ debt–equity decisions when the

static tradeoff theory and the pecking order theory disagree. Journal of Banking &

Finance, 35(5), 1303-1314. https://doi.org/10.1016/j.jbankfin.2010.10.006

Adair, P., & Adaskou, M. (2015). Trade-off-theory vs. pecking order theory and the determinants

of corporate leverage: Evidence from a panel data analysis upon French SMEs (2002–
2010). Cogent Economics & Finance, 3(1), 1006477.

https://doi.org/10.1080/23322039.2015.1006477