A firm finances its activities using funds from debt and equity. Debt refers to loans the firm secures from outside sources. Equity refers money the firm's owners or stockholders invest in the firm. A firm's capital structure is its ratio of long-term debt to equity. An optimal capital structure is the best debt-to-equity ratio for the firm, which minimizes the cost of financing and maximizes the value of the firm.
According to the trade-off theory, the cost of debt is always lower than the cost of equity, because interest on debt is tax-deductible. The cost of equity usually consists of dividends the firm distributes to its owners or shareholders — dividends the firm could delay or reduce. Debt-holders have a prior claim to the firm's funds, and the firm can only pay shareholders after meeting its debt obligations for the period. Debt is cheaper but carries with it the risk of not being able to make payments on time, which could result in bankruptcy. The firm, therefore, has to find an optimal capital structure that minimizes the cost of financing while also minimizing the risk of bankruptcy.
A firm's capital structure can be found mathematically by computing its minimum weighted average cost of capital. For example, if a company uses debt at 4 percent to get 30 percent of its funds and equity at 10.5 percent to get 70 percent of its funds, the firm's weighted average cost of capital is (0.30 X 4 percent) + (0.70 X 10.5 percent) = 8.55 percent. The formula implies that the firm can get a minimum weighted average cost of capital of 4 percent by using debt as its sole source of funds, but it would not be the firm's optimal capital structure because the firm would then face a high risk of bankruptcy.
Other factors also contribute to the unworkable nature of trying to achieve optimal capital structure by using only debt to finance a firm's activities. When a firm increases its debt-to-equity ratio, lenders usually become concerned about the ability of the firm to meet its payments. They then increase the interest rate on the firm's loans. Shareholders also become concerned about bankruptcy and insist on getting a higher rate of return. Both the cost of debt and equity would increase, increasing the weighted average cost of capital.
If a firm knows the cost of equity and debt at all possible levels of debt-to-equity ratio, it could calculate the point at which it gets a minimum weighted average cost of capital, which is its optimal capital structure, according to the trade-off theory. If the firm has a lower debt-to-equity ratio than the optimal level, it would be paying too much for its funds and could decrease the cost of capital by borrowing more money. If it has a higher debt-to-equity ratio than the optimal level, it would also be paying too much for its funds, because lenders and stockholders perceive the firm as being too risky, and the firm could decrease the cost of capital by paying its debt or issuing new equity.
Critics of the trade-off theory disagree that the optimal capital structure can be found using this method. They say that, in real life, shareholders, lenders and managers might not always behave according to the theory. There is an asymmetry of information whereby lenders and shareholders know less about the firm than the managers, who might not act in the firm's best interests.