what is trade offs in principles of business and finance?
Answers
A trade-off (or tradeoff) is a situational decision that involves diminishing or losing one quality, quantity or property of a set or design in return for gains in other aspects. In simple terms, a tradeoff is where one thing increases and another must decrease.
The static trade-off theory and the pecking order theory are two financial principles that help a company choose its capital structure. Both play an equal role in the decision-making process depending on the type of capital structure the company wishes to achieve. The pecking order theory, however, has been empirically observed to be most used in determining a company's capital structure.
The static trade-off theory is a financial theory based on the work of economists Modigliani and Miller. With the static trade-off theory, and since a company's debt payments are tax deductible and there is less risk involved in taking out debt over equity, debt financing is initially cheaper than equity financing. This means a company can lower its weighted average cost of capital (WACC) through a capital structure with debt over equity. However, increasing the amount of debt also increases the risk to a company, somewhat offsetting the decrease in the WACC. Therefore, the static trade-off theory identifies a mix of debt and equity where the decreasing WACC offsets the increasing financial risk to a company.