Corporate Finance: Trade-Off Theory and Pecking Order Theory

BMAN71152 corporate finance

TABLE OF CONTENTS
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REFERENCES...........................................................................................................................6

2.
a.
The static trade off theory pertaining to the capital structure of eth firms tries to balance the
costs of the financial distress with respect to eth tax shield benefit which is derived from
using the debt. In this, there is an optimal capital structure which is basically eth combination
of debt and equity. This theory removes the assumption in respect to eth fact that there will be
no cost to financial distress under the situation when the firm borrows the money (Agyei, Sun
and Abrokwah, 2020). If this assumption is removed then after taking additional debt will not
necessarily lower the WACC. Instead, it will then highlight the point at which the additional
value derived from undertaking additional debt in the form of tax shield will be exceeded by
the value decreasing the cost of the financial distress. This point is considered as the optimal
capital structure and along with that it is the point at which the value of firm is maximized.
On the other hand, in relation to the Pecking order theory which helps in explaining why eth
firms prefers to finance investment proposals with internal sources of funds first, then debt
and on third is equity (Simatupang, Purwanti and Mardiati, 2019). The equity mode of
financing is costlier in comparison to the cost of debt. The issuance of debt gives a positive
signal abut eth undervalued stock and cofidence which the board believes the investment is
profitable. The debt can be easily undertaken for meeting with the long run target which is
because of the reason that the debtholders are needed a lower return in comparison to the
equity holders. Both the ideas or concepts behind the theories are right.
b.
Based upon the empirical research which is being carried out on eth issue states that the
managers with discretion who are being protected from eth various kinds of pressures
pertaining to internal and external governance mechanisms mainly prefers lower leverage
ratios. The external sources of funds is being used in respect to providing positive signal
about eth market that the firm is having stable cash flows and is in the capacity to payback
eth borrowed amount (Yuen and et.al., 2017). This results into increasing the trust of the
shareholders in the firm. While using the equity depicts that eth firm is having unstable cash
flows and also is not in the position to pay back the loan amount. For instance, as per eth MM
theory, if we ignore the taxation then eth total value of a firm is constant irrespective to the
degree of leverage. The behavioral justification for the irrelevance of the capital structure
decision and is mainly lies in the arbitrage process. While if the tax is considered, it will
result into increase in the value of firms and the cost of capital will decline with the increase