The purpose of the trade-off theory of capital structure is to explain the strategy of the firms to finance their investments sometime by equities and sometimes by debts. The theory also studies the corresponding advantages and disadvantages of the financing either by equity or by bond. The trade-off theory actually allows the cost of bankruptcy to exist.
According to Miller, the attractiveness of debt decreases with the personal tax on the interest income. A firm experiences financial distress when the firm is unable to cope with the debt holders' obligations. If the firm continues to fail in making payments to the debt holders, the firm can even be insolvent.
The direct cost of financial distress refers to the cost of insolvency of a company. Once the proceedings of insolvency starts, the assets of the firm may be needed to be sold at distress price, which is generally much lower than the current values of the assets. A huge amount of administrative and legal costs are also associated with the insolvency. Even if the company is not insolvent, the financial distress of the company may include a number of indirect costs like - cost of employees, cost of customers, cost of suppliers, cost of investors, cost of managers and cost of shareholders.
The firms may often experience a dispute of interests among the management of the firm, debt holders and shareholders. These disputes generally give birth to agency problems that in turn give rise to the agency costs. The agency costs may affect the capital structure of a firm. There may be two types of conflicts - shareholders-managers conflict and shareholders-debt-holders conflict.
