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What is Trade-off Theory of Capital Structure?
Trade-off Theory of Capital Structure
In the risk-return trade-off theory of capital structure, there is an optimum level of current assets and/or working capital that a company must maintain to gain the optimum level of profitability. There is another way to look into the risk-return trade-off theory of business companies. It is related to the liquidity of the company.
In fact, there are costs of maintaining current assets at a certain level. One of these costs is the cost of liquidity while the other is the cost of illiquidity.
Excessive Amount of Current Assets
A company’s level of liquidity will be very high if it has an excessive amount of current assets. The company can manage the business in a smooth manner if current asset levels are high, but it will have less return from the assets as the funds are tied in idle funds. In such conditions, stocks earn nothing, and the high levels of debtors reduce the profit margins. Therefore, the cost of liquidity increases in proportion to the increase of current assets.
In case of insufficient current assets, a company is in a position where it cannot meet the current obligations due to a lack of current assets. This may let the company borrow cash at an increased rate of interest. The creditworthiness of the company will also be affected if the level of current assets is low. Thus, the company will find it tough to raise funds in the future. These factors may lead the company to insolvency.
Increase in Current Assets
Lack of current assets may also result in low levels of stocks which may force customers to go to the competitors. A tight credit policy that follows the lack of current assets may lead to a low level of debtors. This may further impair sales and hamper profitability. Thus, low levels of current assets also carry a cost of losses if the levels of liquidity are low.
Balance Between Solvency and Profitability
To derive the optimum level of solvency and profitability, the tangle between them must be balanced. This requires one to minimize the costs -both the liquidity and illiquidity cost as much as possible. It is observed that with the increase in current assets the cost of liquidity of the company increases while the cost of illiquidity decreases and vice-versa.
If we draw a graph of current assets vs liquidity and draw liquidity and illiquidity cost lines along with the increase of current assets, we will obtain a point of minimum costs where the sum of costs of liquidity and illiquidity is the minimum. This is the balancing point of current assets where a company must conclude its current asset levels.
There are some specific points that must be observed while considering the trade-off theory of capital structure. They are as follows −
Both liquidity and illiquidity carry costs and having too little or too much liquidity are harmful to the company. Therefore, the company must balance its liquidity indicated by its current assets.
Excessive current assets make business operations smoother, but it also leads to less return from investments. This occurs as the funds get tied up and there is no extra fund left for operations and productions.
Inadequate current assets halt the business operations and are unwelcomed by the lenders. So, businesses with low current assets often have to face higher interest rates on loans they acquire from lenders. If the business operations cannot gain momentum, too much interest payment can lead the company to bankruptcy.
The trade-off theory of capital structure measure liquidity and illiquidity in terms of current assets. Current assets are the most common feature of all businesses, especially the small ones and so taking current assets as a reference is easier for making estimations.
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