Dynamic trade-off theory: the history of appearance, evolution and main research problems

Abstract

For almost fifty years now, theoretic as well as empirical research seeks to identify determinants of corporate capital structure decisions. While Miller and Modigliani (1958) derive conditions under which the capital structure choice is irrelevant to firm valuation, the subsequent theoretical literature has shown that a firm can influence its value and improve its future prospects by varying its ratio between debt and equity. In particular, Brennan and Schwartz (1986) and Leland (1994) summarized the achievements of so-called static trade-off theory as it was named later. Dynamic capital structure theory appeared as a response to solve problems which lied beyond static trade-off theory instrumentality. Static trade-off could only give an answer about optimal capital structure. Dynamic trade-off primarily concentrates on real capital structure of a company, its correspondence with the optimal one, the reasons for its volatility, the speed and the direction of its change, and also the process of adjustment of real capital structure to the optimal one and the determinants of this process. Not denying but using theoretical and empirical results of competing concepts (pecking order, market timing and free cash flow concepts), dynamic trade-off pretends to create the broadest picture of capital structure. The article will discuss the history of appearance and evolution of dynamic trade-off concept, as well as the results of the latest empiric research in this field.