THE STATIC TRADE-OFF THEORY

Overview:
Debts corporate tax shield
Bankruptcy costs
Indirect costs of financial distress
Debt overhang problem
Other indirect costs of financial distress
The Static Trade-o Theory
Perspective:
Practitioners corner
Academics corner

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Capital Structure: The Static Trade-o Theory

STATIC TRADE-OFF THEORY

Main idea:
Debt has benefits:
Tax Shield: Debt has an advantage over equity for corporate taxes
This advantage is reduced by:
Personal taxes: Equity has an advantage over debt
Non-debt tax shields
Debt has costs:
Debt implies a probability of financial distress:
Bankruptcy costs (usually small w.r.t. potential tax gains)
Indirect costs of financial distress (potentially larger)
Trade-o Optimal capital structure
The tax benefits of debt are firm/industry-specific
Probability and costs of financial distress are firm/industry-specific
Optimal capital structure is firm/industry-specific
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DEBT TAX SHIELD

When a firm generates earnings :
First, it pays the debts interest
Then it pays taxes on the rest at the corporate tax rate
Total after tax cashflow:

Can be rewritten as:

(1 ) ( )
{z
}
to shareholders

}
| {z
to debtholders

(1 )
|
{z
}
all equity firm

}
| {z
tax shield

Proposition (MM with corporate taxes):

The value of a firm with debt equals its value without debt plus the value the tax shield
() = (0) + (Tax Shield)
Proof: By value additivity
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Remarks
Why doesnt MM Proposition I hold?
In eect, the government pays a fraction of the interest
Investors cannot get this tax break on homemade leverage Levered firms are worth more
NB: MM would hold if firm value included the value of the governments tax claim:
Firm Value + (Taxes) is independent of capital structure

Personal taxes
Capital gains are taxed at a lower eective rate than interests (and dividends)
Reduces the benefit of debt over equity (at least in principle)
Non-debt tax shields
Many firms do not pay (much) taxes anyway They cannot fully exploit the tax shield of debt
Example: Tax Loss Carry Forwards (TLCF)

Reduces the benefit of debt over equity for these firms

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(DIRECT) BANKRUPTCY COSTS

Debt implies a risk of bankruptcy

Bankruptcy involves some costs (i.e. some cash flows that would have gone to investors dont):
Legal and advisory fees, administrative and court cost, etc.
Resources spent by management and creditors dealing with bankruptcy
Mismanagement by judges (blocking/delaying non-routine expenditures)
In US, average time spent in bankruptcy: 20 months
NB1: MM is consistent with default and bankruptcy
MM does not assume riskfree debt
MM does not assume how value is split between investors in case of default
NB2: MM is inconsistent with bankruptcy costs
Bankruptcy costs imply that cashflows do depend on financial policy
No debt No bankruptcy No bankruptcy costs
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STATIC TRADE-OFF THEORY

WITH BANKRUPTCY COSTS
As leverage increases:
The tax shield increases
The expected bankruptcy costs increase
The probability of bankruptcy increases
The costs when in bankruptcy (do probably) increase
Static Trade-o Theory of Capital Structure
The optimal leverage (ratio) trades-o these costs and benefits
Firms try to remain close to their target capital structure

Implications
The tax benefits of debt are firm/industry-specific
Probability and costs of financial distress are firm/industry-specific
Optimal capital structure is firm/industry-specific
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ISSUES
Main idea:
Firms tend to be less leveraged than predicted by the STO Theory
The tax gains can be substantial
In principle, firms could escape all taxes by having high enough interest payments
Tax rate ' 13 Such a policy would increase firm value by

13
= 50%
1 13

This is unrealistic for most firms but thats an order of magnitude

Direct bankruptcy costs are generally too small to oset the potentially big tax gains
Value loss in bankruptcy: 5% for large firm, 20% for small firms (Warner (1977), Weiss (1990))
These overestimate the relevant cost:
Need the expected cost as a fraction of firm value at the time when capital structure is decided
Caveat 1: Firm value is low near bankruptcy The above are overestimates
Caveat 2: Ex-ante probability of distress is small

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INDIRECT COSTS OF FINANCIAL DISTRESS

The (direct) costs of actually being in bankruptcy are generally too small to oset tax benefits
But financial distress can have costs due to the mere possibility of default and bankruptcy
Pass up valuable investment opportunities
Inecient/short-sighted actions to avoid default (e.g. cut R&D expenses)
Excessive risk-taking to gamble for resurrection
Assets sold below fair value (fire sales)
Weakened competitive position
Lost confidence of customers, key employees, suppliers,...
Etc.
These are so-called indirect costs of financial distress
They arise due to the risk of default...
... not at the time of default
... and even for firms that end up not defaulting
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THE DEBT OVERHANG PROBLEM:

AN INDIRECT COST OF FINANCIAL DISTRESS

Myers (1977)
Main idea:
Firms nearing financial distress can/will not fund valuable investment opportunities
Existing risky debt Shareholders will not fund some valuable projects as they would
bear the full cost but get only part of the benefits
Perfect renegotiation would solve the problem
The problem arises when renegotiation is imperfect

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Model
To simplify: One firm, no taxes, no discounting, all agents are risk-neutral, two dates ( = 1 2)
Assets in place:

Generate a single cash flow at = 2 equal to { }

Notation: 0 and Pr =

Capital structure:
At = 1, existing debtholders hold debt with face value
At = 2, their repayment (principal + interest) depends on :

= min{; } and = min{; }

Shareholders get the rest

Investment project:
At = 1, shareholders can decide: Invest 0 Probability increases to ( + )
The investment is valuable, i.e. it increases total firm value:
( + ) + [1 ( + )] + (1 )
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or

0
10

Underinvestment
Notation The existing debtholders payo is:

+ Pr =
If is invested, their payo increases by:

The shareholders payo increases by:
|

( )
{z
}
projects value

The shareholders will invest i:

}
| {z
part accruing to
existing debtholders

Risky debt ( 0) Underinvestment: The shareholders ineciently reject projects such that:
0
Intuition: The shareholders would bear the investments entire cost, but get only part of its return
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Remarks
Outside financing does not help:
Competitive capital markets Shareholders must promise new investors claims worth
Their decision problem is unchanged
Indirect cost:
Debt must be risky: No distortion with risk-free debt ( = 0)
But default need not be certain: The cost can arise for firms that end up not defaulting

Key assumption:
The firm cannot issue separate claims only on the projects cash flows
Under this assumption, the analysis also holds with unrelated new project and assets in place

NB: Assuming that investing raises Pr = is a mere modelling trick allowing this
Debt overhang? So far, the idea is not debt-specific: Underinvestment when existing claims are
risky (i.e. 6= 0). Yet the problem is usually associated with debt. We will soon see why.
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Renegotiation/Restructuring
Consider a project that will be rejected due to the debt overhang, i.e. such that:
0
Say shareholders oer creditors to invest if they cut the face value to

+ (1 ) ( )

=
with [0 1]

Debt value

) = + + (1 ) ( )
+ ( + )(
{z
}
|
|
{z
}
projects value

debt value w/o project

Equity value

( + )( )

( ) + ( )
|
|
{z
}
{z
}

equity value w/o project

projects value

Shareholders and creditors are (weakly) better-o They agree to the deal
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Remarks

Financial restructuring
Renegotiation of the initial financial claims avoids the underinvestment problem
Intuition: Shareholders and creditors can find a way to share the value of the new project

Using this sensibly:

Financial distress will trigger renegotiation
If perfect renegotiation is possible, the debt overhang problem disappears
Debt overhang problem arises only when renegotiation is dicult
More general insight:
Same intuition for all costs of financial distress, direct or indirect
Haugen and Senbet (1978):

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New Financing as Renegotiation

Will the shareholders raise and invest if:
They can only issue new equity,
They and the creditors are passive?

If there is only equity outstanding: Yes

Competitive capital market New shareholders break even
Existing shareholders share the positive value
Intuition: In eect, the new issue changes the existing shareholders claim, i.e. and decrease
It can be viewed as forcing foregiveness
If there is some debt outstanding: Not always
The face value of debt is unchanged by the new issue
Debt is senior to equity
The overhang problem is unchanged
Intuition: Due to seniority, the new issue does not change the existing debtholders claim
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Implications

Main insight:
Debt overhang is a renegotiation problem
As we will see, this is a special case of a more general insight: All costs of financial distress must
ultimately be caused by renegotiation problems (Haugen and Senbet 1978)

Ex-ante solutions:
Less debt
Easier-to-renegotiate debt structure: Fewer lenders, fewer classes with dierent maturities/seniorities/etc
Commit ex ante to a suitable renegotiation procedure expost (e.g. bankruptcy law)
Ex-post solutions:
Issue more senior claims and/or shorter maturity claims (as they are de facto senior)
Separate or senior claims on the project: Project finance, asset-backed or secured lending, etc.
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Remarks
Moral hazard
When the firm issues debt, creditors anticipate debt-overhang problem Pay less for the debt
Ex post, shareholders prefer not to invest but they bear this cost ex ante (very general point)
Debt-overhang arises from shareholders inability to commit ex ante to invest ex post
Unconditional foregiveness
Perfect renegotiation quid pro quo: Debt foregiveness on the condition that shareholders invest
If shareholders cannot commit to invest, unconditional debt foregiveness might not restore eciency
Condition for shareholders to have an incentive to invest

Condition for creditors to accept to renegotiate down to

( + )

When these are incompatible, no renegotiation (Bhattacharya and Faure-Grimaud 2001)

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THE RELUCTANCE TO LIQUIDATE PROBLEM:

ANOTHER INDIRECT COST OF FINANCIAL DISTRESS
Jensen and Meckling (1976)
Consider a firm that is in financial distress but that has not yet defaulted on its debt
Shareholders must choose between:
Continuation Single risky cashflow { } with Pr[ = ] =
Liquidation Safe proceeds with certainty
Assumption: Liquidation is ecient, i.e. + (1 )
Assume that the firm has debt with face value ( )
Equitys payo:
Continuation: ( )
Liquidation: max{0; }
Liquidation i:

+ (1 )

Shareholders might choose continuation even if liquidation is ecient

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Remarks

Intuition:
Liquidation kills the equity option
Moreover, shareholders are junior in liquidation
Again, this could be solved with renegotiation (e.g. debt for equity exchange)
A more general point:
When in financial distress, shareholders have incentives to take excessively risky actions
AKA the risk-shifting problem, asset substitution problem, gambling for resurrection problem
Empirical relevance? Financial firms? Delayed distress restructuring?

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STATIC TRADE-OFF THEORY

WITH INDIRECT COSTS OF FINANCIAL DISTRESS
As leverage increases:
The tax shield increases
The expected costs of financial distress increase:
The probability of distress increases
The costs when in financial distress increase
Static Trade-o Theory of Capital Structure
The optimal leverage (ratio) trades-o these costs and benefits
Firms try to remain close to their target capital structure

Implications
The tax benefits of debt are firm/industry-specific
Probability and costs of financial distress are firm/industry-specific
Optimal capital structure is firm/industry-specific
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PRACTITIONERS CORNER:
CHECKLIST

Benefit from debt tax shield:

Profitability, tax rate, tax credits, non debt tax shields...
Probability of distress:
Cashflow volatility, cyclicality, sensitivity to macro-shocks, seasonality,...
Uncertainty: Technology, competition, regulation, business model and delivery (e.g. start-up)...
Costs of financial distress:
Need outside finance to fund key investments (CAPX, R&D, market share,...)
Competitive threat if in distress: Are rivals financially strong?
Assets redeployability: If in distress, who will buy assets? Will buyers be distressed too?
Employees, suppliers, costumers care about financial status

Note: The optimal level of debt can be negative (i.e. CashDebt): R&D,...
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PRACTITIONERS CORNER: PRIVATE EQUITY

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PRACTITIONERS CORNER:
DEBT RATING

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PRACTITIONERS CORNER:
HYBRID CAPITAL

Debt has advantages and advantages: Tax shield vs. Financial distress
What if you could get the best of both worlds?
Scramble to exploit hybrid financing Companies rush to new lucrative funding device
From Financial Times (London); 06 February 2006; Richard Beales and David Wighton
Companies around the world are lining up to exploit a new form of financing that cuts costs of capital
and could prove one of the most crucial developments in corporate funding in two decades.
Bankers are predicting explosive growth in a new generation of so-called hybrid securities, creating a
potentially lucrative source of fees for investment banks. Companies will increase the amount raised
from these securities tenfold to Dollars 40bn this year in the US alone, according to some Wall Street
forecasts.
The new securities combine the most advantageous features of debt and equity to reduce companies
tax bills and cut their financing costs while bolstering their credit ratings (...)
Investors view the hybrids as long-term subordinated debt, meaning they would rank behind all other
creditors in a bankruptcy. The hybrids carry some equity-like risks, such as the possibility interest
payments might be deferred, but have no share price upside - though investors can gain from early
repayment. (...)
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ACADEMICS CORNER:
TESTING THE THEORY
Leverage: Time series
The theory predicts fairly stable leverage ratios
Empirically, there seems to be mean reversion in leverage ratios
Auerbach (1985)
Estimate the following regression for ' 200 firms over 1958-77:

= 0( 1) + 0

where
: Target Debt/Assets ratio, determined by firm characteristics (firm + year dummies, TLCF)
: Change in Debt/Assets ratio
: Financial deficit
Main result:
Debt/Assets falls by 274% for each 10% increase in lagged Debt/Assets
When Debt/Assets is abnormally high, firms reduce it
Consistent with firms trying to keep Debt/Assets within some bounds
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But...
Bankruptcy costs: Cross-section
Microsoft paradox: More profitable firms tend to have less debt, not more
Operating risk has little explanatory power
Tax-shield: Cross-section
More taxable firms (pre-interest) tend to have less debt
Tax-shield: Time series
Leverage ratios do not appear to be correlated with corporate tax rates
However...
We dont have yet an alternative theory to test the STO against

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ACADEMICS CORNER:
GOING DEEPER INTO THE THEORY

Exogenous vs. Optimal Financial Claims

So far we have assumed that firms use debt and equity
We have not explained why they use these and not other financial claims
Particularly problematic given that we have argued that problems arise with both
In modern theories, financial contracts must be optimal given the model

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Something Subtle: Entrepreneurial vs. Managerial Firms

Indirect costs of financial distress are due to shareholder-debtholder conflict

The model fits well entrepreneurial firms but is used for large manager-run firms
This requires a non-standard assumption: Managers act in the interest of shareholders
With this assumption (and with the caveat in mind):
No scope for equity overhang
The rest of the analysis goes through unchanged
Without the assumption, the problem could be solved by an appropriate managerial contract:
If the manager is unbiased, a flat contract will do
If he is biased, a contract can align his interest with firm value (Dybvig and Zender 1991)
Coherent interpretation: Shareholders can secretely undo the managers contract (Persons 1994)
OK, but why only shareholders? Isnt this just shifting the problem?
Dewatripont and Tirole (1994): Theory with endogenous manager-shareholder congruence
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REFERENCES
(s) denotes surveys, books, syntheses, etc.
Auerbach, Alan J. (1985), Real Determinants of Corporate Leverage, in Corporate Capital Structures in the United
States, Friedman (ed.), University of Chicago Press.
Bhattacharya, Sudipto, and Antoine Faure-Grimaud (2001), The Debt Hangover: Renegotiation with Non-Contractible
Investments, Economics Letters, 70, 413-419.
Bradley, Michael, Gregg A. Jarrell, and E. Han Kim (1984), On the Existence of an Optimal Capital Structure, Journal
of Finance, 39, 857-878.
Bulow, Jeremy, Lawrence H. Summers, and Victoria P. Summers (1990), Distinguishing Debt from Equity in the Junk
Bond Era, in Shoven and Waldfogel (eds.), Debt, Taxes and Corporate Restructuring, Brookings.
DeAngelo, Harry, and Ronald W. Masulis (1980), Optimal Capital Structure under Corporate and Personal Taxation,
Journal of Financial Economics, 8, 3-29.
Dewatripont, Mathias, and Jean Tirole (1994), A Theory of Debt and Equity: Diversity of Securities and ManagerShareholder Congruence, Quarterly Journal of Economics, 109, 1027-1054.
Dybvig, Philip H., and Jaime F. Zender (1991), Capital Structure and Dividend Irrelevance with Asymmetric Information, Review of Financial Studies, 4, 201-219.
Fischer, Edwin O., Robert Heinkel, and Josef Zechner (1989), Dynamic Capital Structure Choice: Theory and Tests,
Journal of Finance, 44, 19-40.
Graham, John (1996), Debt and the Marginal Tax Rate, Journal of Financial Economics, 41, 41-73.
Graham, John R. (1999), Do Personal Taxes Aect Corporate Financing Decisions?, Journal of Public Economics,
73, 147-185.
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(s) Graham, John R. (2003), Taxes and Corporate Finance: A Review, Review of Financial Studies, 16, 1074-1128.
(s) Grinblatt, Mark, and Sheridan Titman (1998), Financial Markets and Corporate Strategy, Irwin/McGraw-Hill, chapter
13.
(s) Harris, Milton, and Artur Raviv (1991), The Theory of Capital Structure, Journal of Finance, 46, 297-355.
(s) Harris, Milton, and Artur Raviv (1992), Financial Contracting Theory, in Advances in Economic Theory, Laont
(ed.), Cambridge University Press.
(s) Hart, Oliver D. (1995), Firms, Contracts and Financial Structure, Oxford University Press.
Haugen, Robert A., and Lemma W. Senbet (1978), The Insignificance of Bankruptcy Costs to the Theory of Optimal
Capital Structure, Journal of Finance, 33, 383-393.
Kraus, Alan, and Robert H. Litzenberger (1973), A State Preferences Model of Optimal Financial Leverage, Journal
of Finance, 28, 911-922.
MacKie-Mason, Jerey K. (1990), Do Taxes Aect Financing Decisions?, Journal of Finance, 45, 1417-1493.
Marsh, Paul (1982), The Choice Between Equity and Debt: An Empirical Study, Journal of Finance, 37, 121-144.
Miller, Merton (1977), Debt and Taxes, Journal of Finance, 32, 261-276.
Myers, Stewart C., (1977), The Determinants of Corporate Borrowing, Journal of Financial Economics, 5, 147-175.
(s) Myers, Stewart C. (2001), Capital Structure, Journal of Economic Perspective, 15, 81-102.
Persons, John (1994), Renegotiation and the Impossibility of Optimal Investment, Review of Financial Studies, 7,
419-449.
Rajan, Raghuram, and Luigi Zingales (1995), What Do We Know About the Capital Structure? Some Evidence from
International Data, Journal of Finance, 50, 1421-1460.
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Shyam-Sunder, Lakshmi, and Stewart C. Myers (1999), Testing Static Trade-O Against Pecking Order Models of
Capital Structure, Journal of Financial Economics, 51, 219-244.
Strebulaev, Ilya (2007), Do Tests of Capital Structure Theory Mean What They Say? Journal of Finance.
(s) Swoboda, Peter, and Josef Zechner (1995), Financial Structure and the Tax System, in Jarrow, Maksimovic and
Ziemba (eds.), Handbook of Operations Research and Management Science, Vol. 9, North-Holland, 767-792.
Titman, Sheridan, and Roberto Wessels (1988), The Determinants of Capital Structure Choice, Journal of Finance,
43, 1-20.
Warner, Jerald B. (1977), Bankruptcy Costs: Some Evidence, Journal of Finance, 32, 337-347.
Weiss, Lawrence A. (1990), Bankruptcy Resolution: Direct Costs and Violation of Priority of Claims, Journal of
Financial Economics, 27, 285-314.
Zechner, Josef (1990), Tax Clienteles and Optimal Capital Structure Under Uncertainty, Journal of Business, 63,
465-491.

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PROBLEMS
Problem 1 (Warm-up: True/False)
Say whether the following statements are true or false, and explain briefly your answers.
a) The static trade o theory implies that all else equal, firms in countries with higher corporate tax rate should have
more debt.
b) The static trade o theory implies that firms should try to locate in countries with high corporate tax rates so as to
increase their tax shield.
c) The static trade o theory implies that firms that have made losses in the recent past should have less debt.
Problem 2 (Tax Shield Warm-up)
Is the following statement true or false? Explain. The static trade-o theory implies that all else equal, firms are better
o locating in countries with higher corporate tax rates because in these countries the tax shield of debt is higher.
Problem 3 (MM with Corporate and Personal Taxes)
This problem considers the eect of both corporate and personal taxation on the debt-equity trade-o. Consider a firm
generating cashflows in an infinite number of periods = 0 1 2. The firm keeps debt with a constant face value ,
i.e. each year it pays interests but never the principal . The debt is riskfree and its value is . Let be the riskfree
rate.
Corporate taxes: Let be the corporate tax rate. Interest payments are not subject to corporate taxes, i.e.. they provide
a tax shield to the firm.
Personal taxes: Individuals also pay taxes on their financial income. Let denote the personal tax rate individual
investors pay on interest payments they receive from their debt holdings. Personal taxes on equity income are more
complex. Indeed, equity income takes two forms: (i) dividends, i.e. cash paid out to shareholders and (ii) capital gains,
i.e. an increase in the stock price. Dividends and capital gains are usually taxed at dierent rates. Dividends tend to
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be taxed at the same rate as interest income. Capital gains instead, tend to be taxed at a lower rate. Also, the gains
are taxed only when they are realised, i.e. when the investor sells shares. Therefore, the tax on capital gains can be
postponed, sometimes for years. For these reasons, equity income is on average taxed at a lower rate than interest
income. To simplify, lets assume that all equity income is taxed at a rate .
a) What is the annual after (corporate and personal) tax income of the firms shareholders?
b) What is the annual after (corporate and personal) tax income of the firms debtholders?
c) Show that relative to an all equity firm, debt decreases total (corporate and personal) annual taxes by a positive or
negative amount equal to:
[(1 ) (1 ) (1 )]

d) Show that the value of the debt is:

= (1 )
e) Prove the MM Proposition with corporate and personal taxes, i.e. show that if () is the value of the firm then:

(1 ) (1 )

() = (0) + 1
(1 )
f) What is the value of the tax shield absent personal taxes? Should the firm issue debt?
g) What is the value of the tax shield when personal tax rates for debt and equity are the same? Should the firm issue
debt?
h) Relative to the case of no personal taxes, do personal tax considerations increase or reduce the attractiveness of debt
financing relative to equity financing?
i) In principle, is it possible for equity to have an overall (corporate + pesonal) tax advantage over debt? Explain.
Problem 4 (Miller Equilibrium and Short Sales)
Read about the Miller Equilibrium (e.g. in Grinblatt and Titmans Financial Markets and Corporate Strategy). Does the
Miller Equilibrium rely on the assumption that short sales are not possible? Explain.
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Problem 5 (Debt Overhang)

A firms assets in place generate a cash flow [0 +) at = 1, distributed according to the c.d.f. . The firm has
existing debt with face value maturing at = 1. At = 0, it faces a new project requiring an investment outlay
and that would generate with certainty. The new project is valuable, i.e, 0.
a) Give the condition under which the existing shareholders will undertake the new project.
b) Is the firm more or less likely to invest when is higher? Explain.
c) Consider two distributions 1 and 2 with 1 () 2 (). Is the firm more likely to invest when = 1 or
= 2 ? Explain.
Problem 6 (Static Trade-o Theory and Non-Debt Tax Shields)
The model has two dates ( = 0 1), no discounting
and universal risk-neutrality. A firms assets generate a cashflow

at = 1, uniformly distributed over with . (Assume throughout that is large enough).

The corporate tax rate is . For simplicity, ignore the distinction between interest and principal by assuming that if the
firm has debt outstanding, the total payment due at = 1, , is tax-deductible. Assume also that the firm has a tax
credit with . In case of bankruptcy ( ), no taxes are paid and the cashflow is decreased by a
bankruptcy cost . What is the optimal debt level at = 0, i.e. the level of debt maximizing total firm value?
How does it depend on , and ? Explain briefly.

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