The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger  who considered a balance between the dead-weight costs of bankruptcy and the tax saving benefits of debt. Often agency costs are also included in the balance. This theory is often set up as a competitor theory to the pecking order theory of capital structure. A review of the literature is provided by Frank and Goyal.
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Scientific Research An Academic Publisher. Kraus, A. The Journal of Finance, 28, ABSTRACT: In this study, we examine whether and to what extent the main stream capital structure theories developed in Western countries apply to Chinese listed companies during its most recent transition period after year Specifically, we examine a variety of trade-off and pecking order models and compare their performance by nesting these two different models in the same regression.
Using market-based leverage data from non-financial Chinese listed firms during the period from to , we present empirical evidence indicating that: firstly, equity tracks the financing deficit better than debt in Chinese firms, which is not consistent with the pecking order theory. Secondly, Chinese firms seem to be more sensitive in expanding debt for meeting their financing needs than in using surplus for retiring debt. Thirdly, Chinese firms have an optimal market-based leverage ratio.
Both the partial adjustment and error correction models suggest that Chinese firms adjust towards target leverage slowly before However, after , they accelerate their leverage adjustments at a speed as fast as that documented in the developed markets. The increasing adjustment speeds are attributed to the shrinking transaction costs and agency costs caused by recent currency and share-split structure reforms.
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Trade-off theory of capital structure
A State-Preference Model of Optimal Financial Leverage
A State-Preference Model of Optimal Financial Leverage.