Trade-Off Theory of Capital Structure

Interest on debt is tax-deductible in many countries, creating a tax shield that adds value. But more debt also increases the probability of financial difficulty, bringing direct costs, such as legal fees in bankruptcy, and indirect costs, such as lost customers, departing staff and missed investment opportunities.

According to the theory, each company has a target level of debt where the marginal benefit of the tax shield equals the marginal cost of financial distress. This is its optimal capital structure.

For example, a company with stable cash flows and valuable physical assets, such as a utility, faces lower distress costs and so should carry more debt. A young technology company with uncertain cash flows and mostly intangible assets faces higher distress costs and should carry less.

The theory explains broad differences in debt levels between industries. But it struggles to explain why many highly profitable companies, which could benefit most from tax shields, carry little debt. The pecking order theory offers an alternative explanation.