An Empirical Application of the Trade-Off Model for Companies in the Dow Jones Industrial Average

Abstract

This study develops a dynamic model of optimization of the value of the company following the postulates of the theory of Trade-Off. The model includes Bystrom formulation for calculating the cost of bankruptcy in the search the optimal debt. Our model is innovative in several respects: 1) raises calculate the cost of bankruptcy easily. This model is easy to implement in firms 2) calculates the cost of debt endogenously. 3) The calculation is dynamic. We determine the cost of debt and the cost of capital for each unit of additional debt. The proposed model has been applied to the companies that make up the Dow Jones Industrial Average (DJIA) in 2007. We have used consolidated financial data from 1996 to 2006, published by Bloomberg. We have used simplex optimization method to find the debt level that maximizes firm value. Then, we compare the estimated debt with real debt of companies using statistical nonparametric Mann-Whitney. The results indicate that 63% of companies do not show a statistically significant difference between the real and the estimated debt.