Dynamic Trade-off Theory of Capital Structure: an Overview of Recent Research

Abstract

The trade-off theory of capital structure asserts that a firm chooses the level of debt by balancing the costs of financial distress and benefits of tax shield.  In dynamic trade-off models it is assumed that costs of constant capital adjustment are high and thus firms will change capital structure only if benefits exceed costs. Therefore, there is an optimal range, outside of each leverage changes, but remains unchanged inside. Companies try to adjust their leverage when it reaches the boundary of the optimal range. Subject to types of adjustment costs firms reach target ratio faster or slower. Proportional changes imply slight correction, whereas fixed changes imply considerable costs. Dynamic trade-off models have a great potential to determine, predict and investigate capital structure choice of firms. Firms can adjust their structure each year by a share of difference between current leverage and target optimal leverage, or firms can adjust capital structure to the optimal but not too often, so between such adjustments capital structure is not optimal. This paper examines the modern dynamic trade-off theory of capital structure, presenting a review of a variety of notable studies, analyzing their interrelations and contribution to the general concept development.  This paper considers five main aspects: investments and cash flows, retained profit and payout policy, the impact of the cost of capital, the value of options on the suspension of capital structure decisions and maximization. We start the analysis with the pioneering articles considering basic dynamic trade-off models under a branch of assumptions, continuing with an established model which throw some restrictions out, and eventually focusing on the issues of adjustment speed to the target leverage and macroeconomic influence on capital structure, which were repeatedly addressed in studies over the last years.