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BRILLIANT’S Capital Structure Theories 361

costs are least for internal funds, low for A{V[a³V Bí¶y H$s bmJV B§Q>Z©b ’§$S²>g Ho$ {bE
debt and highest for equity. There is also g~go H$‘, S>oãQ> Ho$ {bE H$‘ VWm B{³dQ>r Ho$ {bE
the negative signaling to the stock market A{YH$V‘ hmoVr h¡& ñQ>m°H$ ‘mH}$Q> ‘| B{³dQ>r Bí¶y
associated with issuing equity, positive H$aZo go {ZJo{Q>d [g½ZqbJ, S>oãQ> Ho$ gmW nm°Or{Q>d
signaling associated with debt. {g½ZqbJ g§~§{YV h¢&
3. Trade off theory 3. Q´>oS> Am°’$ ϶moar
The trade-off theory of capital structure is H¡${nQ>b ñQ´>³Ma H$s Q´>oS>-Am°’$ ϶moar dh {dMma h¡
the idea that a company chooses how much {Ogo EH$ H§$nZr MwZVr h¡ {H$ bmJVm| VWm bm^m| H$m g§VwbZ
debt finance and how much equity finance to ~ZmH$a Cn¶moJ {H$VZr S>oãQ> ’$m¶Z|g VWm {H$VZr B{³dQ>r
use by balancing the costs and benefits. The
classical version of the hypothesis goes back to ’$m¶Z|g H$a|& hmBnmoWr{gg H$m ³bm{gH$b dO©Z H«$mCg
Kraus and Litzenberger who considered a VWm {bOoZ~J©a VH$ OmVm h¡ {OÝhm|Zo ~¢H$aßQ>gr H$s S>oS>-
balance between the dead-weight costs of d¡Q> H$m°ñQ²>g VWm S>oãQ> Ho$ Q>¡³g goqdJ bm^ Ho$ ~rM g§VwbZ
bankruptcy and the tax saving benefits of debt. H$m {dMma {H$¶m h¡& A{YH$m§eV… EO|gr H$m°ñQ²>g ^r ~¡b|g
Often agency costs are also included in the
‘| gpå‘{bV H$s OmVr h¢& ¶h {gÕm§V A{YH$m§eV… H¡${nQ>b
balance. This theory is often set up as a
competitor theory to the pecking order theory ñQ´>³Ma H$s noqH$J Am°S>©a ϶moar H$s à{V¶moJr ϶moar Ho$ ê$n
of capital structure. A review of the literature ‘| ñWm{nV H$s OmVr h¡& gm{h˶ H$s g‘rjm ’«¢$H$ VWm
is provided by Frank and Goyal. Jmo¶b Ûmam àXmZ H$s J¶r h¡&
An important purpose of the theory is to ϶moar H$m EH$ ‘hÎdnyU© CÔoí¶ V϶ H$m dU©Z
explain the fact that corporations usually are H$aZm h¡ {H$ gm‘mݶV… H$m°nm}aoe§g H$mo S>oãQ> VWm B{³dQ>r
financed partly with debt and partly with go Am§{eH$ ê$n go ’$m¶Z|g {H$¶m OmVm h¡& ¶h ~VmVm h¡
equity. It states that there is an advantage to {H$ S>oãQ> go ’$m¶Z|qgJ H$m bm^ h¡, S>oãQ> Ho$ Q>¡³g bm^ h¢
financing with debt, the tax benefits of debt and
there is a cost of financing with debt, the costs of VWm S>oãQ> go ’$m¶Z|qgJ H$s bmJV h¡, S>oãQ> H$s ~¢H$aßQ>gr
H$m°ñQ²>g VWm Zm°Z-~¢H$aßQ>gr H$m°ñQ²>g (CXmhaU Ho$ {bE,
financial distress including bankruptcy costs of
debt and non-bankruptcy costs (e.g., staff ñQ>m’$ brqdJ, gßbm¶g© H$s hm{ZH$maH$ ^wJVmZ eV],
leaving, suppliers demanding disadvantageous ~m§S> hmoëS>a/ñQ>m°H$hmoëS>a g§Kf© Am{X) g{hV ’$m¶Z|{e¶b
payment terms, bondholder/stockholder {S>ñQ´>og H$s bmJV|& S>oãQ> ‘| AmJo d¥{Õ Ho$ ‘m{O©Zb ~oZr{’$Q²>g
infighting etc.). The marginal benefit of further H$‘ hmoVo h¢ O~ S>oãQ> ~‹T>Vm h¡ O~{H$ ‘m{O©Zb H$m°ñQ>
increases in debt declines as debt increases, ~‹T>Vr h¡ {Oggo {H$ EH$ ’$‘© Omo BgH$s g§nyU© d¡ë¶y H$mo
while the marginal cost increases, so that a firm AZwHy$b ~Zm ahr h¡ Bg Q´>oS>-Am°’$ na ܶmZ XoJr O~
that is optimizing its overall value will focus on
MwZmd H$aVo h¢ {H$ ’$m¶Z|qgJ Ho$ {bE {H$VZr S>oãQ> VWm
this trade-off when choosing how much debt
and equity to use for financing. B{³dQ>r Cn¶moJ H$a|&
Evidence à‘mU
The empirical relevance of the trade-off Q´>oS>-Am°’$ ϶moar H$s àm¶mo{JH$ àmg§{JH$Vm na
theory has often been questioned. For example, A{YH$m§eV… àíZ CR>m¶o OmVo h¢& CXmhaU Ho$ {bE, {‘ba
Miller compared this balancing as akin to the Zo EH$ hm°g© VWm EH$ a¡{~Q> Ho$ ñQ²>¶y ‘| hm°g© VWm a¡{~Q>
balance between horse and rabbit content in a H§$Q>|Q> Ho$ ~rM g§VwbZ Ho$ {bE Bg g§VwbZ H$s VwbZm H$s h¡&