Static trade-off theory
Incorporate bankruptcy risk to M and M’s theory and you will arrive at the same conclusion as the traditional theory of gearing – i.e. that an optimal gearing level exists.
Firms can reach the optimum level by means of a trade off.
This is achieved by striking a balance between the benefits and the costs of raising debt.
Provided a company is in a static position ie not in a period of extreme growth, it is likely to have a gearing policy that is stable over time.
Benefits of debt
The benefits of debt relate to the tax relief that is enjoyed when interest payments are made – the cheaper debt finance will reduce the weighted average cost of capital and increase corporate value.
Costs of debt
The costs of debt relate to the increases in the costs of financial distress (eg bankruptcy costs) and increases in agency costs that arise when the company exceeds its optimum gearing levels.
The resultant increase in required returns demanded by investors cause the weighted average cost of capital of the company to increase and hence corporate value to fall.