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Trade-off theory of capital structure (Baxter 1967; Kraus & Litzenberger 1973) suggests that firms choose their capital structure by balancing the advantages of borrowing, mainly tax savings, with the costs associated with borrowing including bankruptcy costs. This trade-off implies the existence of a target leverage that maximizes the value of the firm. The existence of a target, which is at the heart of the theory, requires that any deviation from that target leverage should be adjusted.

The dynamic version of the trade-off theory explicitly accounts for the adjustment behavior of the leverage ratio where adjustments take place when the cost of deviation from the target exceeds the cost of adjustment towards that target (Fischer et al. 1989). One advantage of the dynamic feature is that since the adjustment towards the target is a characteristic of trade-off theory, it can be used to validate the trade-off theory against other theories of capital structure that do not presume the existence of target leverage, ie pecking order theory (Myers & Majluf 1984) and timing theory (Baker & Wurgler2002).