TRADE OFF - THEORY

Trade – off theory:

Trade – off theory allows bankruptcy costs to exist. It states that there is an advantage to financing with debt, the tax benefit of debt and there is a cost of financing with debt, the bankruptcy costs of debt. The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that is optimizing its overall value will focus on this trade – off when choosing how much debt and equity to use for financing. Empirically, this theory may explain differences in D/E ratios between industries; however it doesn't explain differences within the same industry.

Meaning of Financial Leverage

The use of fixed-charges sources of funds, such as debt and preference capital along with owner's equity in the capital structure described as financial leverage gearing or trading on equity. The use of the term trading on equity is derived from the fact that is the owner's equity that is used to raise debt; that is, the equity that is traded upon.

Financial leverage is defined as the ability of a firm to use fixed financial charges to magnify the effect of change in E.B.l.T on the firm's earning per share. The financial leverage occurs when a firm's Capital Structure contain obligation of fixed financial charges. For instance, interest on debentures, dividend on preference share etc., along with owner's equity to enhance earning of equity shareholder's. The fixed financial charges do not vary with the operating profit. They are fixed and are to be paid irrespective of level of operating profit. The ordinary shareholders of firm are entitled to residual income i.e. earning after fixed financial charges.

The financial leverage employed by a company is intended to earn more on the fixed charges funds than their costs. The surplus (or deficit) will increase (or decrease) the return on the owner's equity. The rate of return on the owner's equity is levered above or below the rate of return on the owner's equity.