The Tradeoff Theory as a Method of Choosing Capital Structure: Effects of Debt and Tax on the Firm Value

Abstract

We analyze the trade-off theory and its underpinnings. All those papers commit the same error: While analyzing the influence of debt and tax on the firm value, they do not consider debt redemption. This approach turns the firm into a generator of arbitrage profits, making void all results achieved in the papers. Using the Extended Merton model, which takes account of debt, its redemption, tax, and the tax shield, we compute the asset distributions for an all-equity firm and the identical levered firm. Contrary to the general belief that a medium-size debt is beneficial for the firm, characteristics of the levered firm are inferior to the same characteristics of the unlevered firm. The anticipated gains from tax deductions are the phantoms created by errors in the papers. Our analysis of debt and tax on the firm value can be helpful for managers as a method of computing the consequences of capital structure decisions.