Trade-Off Theory

Trade-Off Theory

According to the static trade-off theory firms with higher profits tend to have higher leverage ratio.   But this statement contradicts with empirical evidence: more profitable companies have lower leverage ratio. Such findings lead to rejection of the static trade-off theory and more attention to other theories such as dynamic trade-off theory, pecking order theory and other.
In the given article, Frank and Goyal pursue the aim to prove that the literature has misinterpreted the evidence as a result of applying irrelevant empirical methods (leverage ratios). For example, leverage ratios do not distinguish variations that operate through an effect on E and D.   The static theory gives results for financial decisions at the margin, while leverage ratios are an evaerage of totals. The difference in cost structure of large and small firms is also omitted and leads to wrong results. So the authors argue that such ratios have undesirable properties for examining the static trade-off theory.  
Conducting the research, the authors obtained the data from Compustat and CRSP. Frank and Goyal also state that using leverage ratios is not right, because it omits several features. They investigated the static trade-off model of capital structure using 2 regressions that explain debt and equity respectively. The authors describe how to deal with the exogeneity of profits. 
Frank and Goyal research led to several results: highly profitable firms issue debt and buyback shares while less profitable profitable firms reduce debt and issue equity. Furthermore, firm size plays an important role in determining its capital structure. Comparing with leverage ratios, firm size is not taken into account. Larger firms are more active in the debt market, while smaller firms are more active in the equity market. The researchers also consider that market conditions (market timing) should be observed when making financing decisions. When there are favorable market conditions, large firms have...

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