The selected topic is on the trade-off theory (TOT). TOT assumes that organizations choose how to allocate their resources, comparing the tax benefits of debt with the bankruptcy costs. Due to this, firms tend to consider the optional debt ratio. It further states that the optimal structure in cooperation in a trade-off between the interest taxes to the distress of financials. Organizations with tangible assets and much of taxable incomes to be protected then they should have high target debt ratios. This theory can be used to explain why there are differences in capital structures in different companies. However, in reality, this theory predicts the opposite since profitable organizations have a broad scope for tax shields. Therefore, they are expected to have a higher debt level, but they have a lower debt ratio. Due to this, the theory has brought about a lot of arguments among various scholars. Some of these scholars have come up with multiple approaches to challenge TOT. On the other side, some have increase studies on it and give it firm support. Therefore, this paper is aimed at reviewing various journals that have written about the trade-off theory and identify different stands of other scholars on the approach.
Philippe and Mohamed researched to test the assumption of trade-off theory regarding cooperative leverage. In their study, they used the debt ratio as the dependent variable. Philippe and Mohamed based their study on SMEs since they believed that these organizations create a lot of employment, and they usually face a continuous need for funding; thus, they can either access internal or external funds. Therefore, they were aiming at finding out if the controversy that exists in TOT can apply appropriately to SMEs since it mostly focuses on large firms. They conducted their study on various SMEs in French. In their research, they failed to identify size effect; thus, they couldn’t confirm or reverse the prediction of TOT. Also, they found out that the cash flow of an organization increases with an increase in the existence of the firm, and there is less resort to debt financing to such firms. This finding rejected the TOT. The other conclusion that these authors made from their research is that profitability negatively influences the debt ratio is declining the predictions of TOT. Philip and Mohammed indicated that the growth potential of an organization it will drive its demand for external financing, and debt turns out to be the best source of their funding. However, they indicated that guarantees are prerequisite to acquiring funding since they reduce agency costs, and they promote more creditors to come into the funding relationship, thus supporting the TOT theory. Therefore, these authors ended up disagreeing with the trade-off theory since most of the results were centrally opposite to its assumption and prediction. They further argue that currently, no approach can determine the capital structure concerning SMEs.
Tri gurnarish researched Indonesian stock exchange to economically test if the companies that carry out stock exchange follow the theory of trade, which predicts optimal capital structure. The author was aiming at examining if the philosophy is being practiced by then companies or not. The author picked Indonesia since there have been differing results on the theory from developed nations such as the United States. Due to this, he decided to focused on the dominant of dominant theories such as picking-order theory and trade off theory on the capital structure in Indonesia. Her stock exchange is characterized by the significant shareholder who differs from other nations that face a big challenge between the managers and the company owners. Also, they argued that there had been a lot of studies that have mixed results on the trade-off theory. From his analyses, he found out that the stock exchange companies in Indonesia apply trade-off theory. Therefore, this shows that the capital structure of the listed companies is mostly funded based on optimal capital structure. The optimal capital structure involves the mixing of debt and equity financing to maximize the market value of the company while minimizing the cost of its capital. The lowest investment comes from liability due to its tax deductibility level. From their finding, the stock exchange companies use debt and stock funding that will help them raise more value for the firm. Also, this usage of optimal capital structure is depicted by the high prices of the stock. From his finding, yyy concluded that trade-off theory is applicable when firms that set a target debt-to-value ratio and they move towards their goal. He added that the set target is determined through balancing debt tax shields against the cost of bankruptcy.
A study conducted by olumuyiwa, odusanya and olowofela trade-off theory of optimal capital structure and adjustment in Nigeria indicated that there is a negative relationship between the speed and the cost of change of firms in Nigeria. He stated that different organizations use different sources of finance at different periods. Therefore as the trade-off theory states, a firm’s transactional costs and speed of change to their optimal target vary with time and space. The article states that as per the prediction of trade-off theory, there exists an inverse correlation between cost and speed of adjustment to the optimal debt aim. The study found out that there was a high adjustment speed of firms in Nigeria towards optimal position. This contradicted the finding of studies done I developed countries where the adjustment speed is low, and the cost is relatively high. They established that this was caused by the fact that financial markets for long term debt and equity are still not developed well in the country. The majority of the firms depend on private debt funding, mostly from commercial banks. Also, they found out that the cost of adjustment was relatively low. This finding supports the negative prediction of the trade-off theory of capital structure. The authors concluded that the stock exchange firms adjusted faster to meet their target debt position, and they also incur less cost during adjustment compared to their counterparts from developed countries. Also, they indicated the lack of bond market; it limits the firms from acquiring long term financing. Therefore, in this case, the authors are supporting the negative aspect of trade-off theory since there are no financing firms that can be used to trade the tax interest in financing distress.
A study conducted by agha 2014 indicated that trade-off theory has long dominated the capital structure decisions, but currently, market timing theory is challenging TOT theory. As a result of this, he had to research to examine the role of different capital structure theories on debt preference decision making. The article shows how capital structure needs a decision-making tactic to handle difficult situations. Trade-off theory aids in capital structure management. The author supports the theory in his analyses. He states that the TOT aids the leverage to construct capital structure by assuming the leverage benefit. As it is sated in the TOT prediction, the authors also agree that debt is only be considered beneficial due to the debt tax shields that aids in reducing the expected tax bills and, in turn utilizing the after-tax cash flow. The journal also states that many firms confirm the role of target leverage. The author also favors the trade-off theory in leverage decision by examining the relative importance of the 39 factors. Much time forms are a bit reluctant to their financial regulations; however, to move to the target leverage they end up buying back their securities. Agah further states that trade-off theory explains capital structure more than other capital structure theories.
Additionally, he argues that the TOT has got only one weakness- profitability is negatively correlated to debt. Therefore, from this, we can observe that this article supports the trade-off theory when it comes to debt preference decision making over other capital structure theories. However, the journal suggests that in the future, the approach will need more development for TOT ideas to be included since future dynamic models will stop assuming results.
Tarek researched to establish the capital structure of organizations and their explanation of their contest as per the trade-off theory. The article analyses the determinant of the capital structure of firms in Tanis. It does this by finding out if there is an existence of a dynamic model of adjustment to the leverage ratio. From this, two successive complementary models were validated. These models include the Static and dynamic model, which is made up of transactional cost variables to observe how one can conclude about a speed adjustment letting firms get near to the target ratio. The research found out that when it comes to static, profitability and asset structure are the primary explanatory variables on the level of leverage of the Tunisian organization.
On the other hand, the dynamic model indicates that the more significant results appear at the adjustment level cost, which is relatively high, thus brought about a slow adjustment toward the optimal ratio. The Tunisian firm shifts slowly towards the target ratio, and a high cost is involved in the changing process. Also, the article states that the bank systems play the most extensive role in funding, and it also says that the cost could be higher if the funding role were performed by the market bond. The author states that the high adjustment cost is brought about by inefficient quality control exercised by the banks. When it comes to size, the article states that the larger the firm, the lesser the firm appeals to debts. The author further says that companies show a need for external financing to an organization that has got consistent cash flow. Therefore, this article supports the application of the trade-off theory in organizations.
From the analyses, it can be observed that various scholars have tried to study and apply trade-off theory in the capital structure of the firms. These studies have been conducted in developed and developing countries around the world. Much of the articles tried to evaluate the assumption of the trade-off theory on the leverage ratio. The majority of the materials have concurred with the premises of the TOT on the leverage rate. They have, in one way or the other, recognized the role that the leverage ratio play in the adjustment and the cost involved in the processing of change. However, there have been three results on the period taken to adjust and the cost involved. In the developed country where they have a well-established bond market, the firms change slowly, and the price included is high. In developing countries, the bank plays a significant role in funding the shifting period, and the bank efficiency rate most determines the cost involved. Nations with banks with a high level of efficiency then adjust first, and the cost involved is low. On the other hand, countries with banks that have insufficient quality control will end incurring the high cost of adjustment, and they will also end up taking a long time to adjust. Many organizations will prefer the trade-off theory when they are selecting a capital structure model to apply. Firms prefer this theory since it explains capital structure more than other capital structure theories. Also, this theory has got minimal weaknesses compared to other approaches. However, the theory has got a controversy since profitable organizations have a broad scope for tax shields. Therefore, they are expected to have a higher debt level, but they have a lower debt ratio.