MN7705: Capital Structure Theories' Impact on Corporate Strategy

This report provides a comprehensive analysis of capital structure theories, specifically focusing on the Trade-off and Pecking Order theories. It begins with an introduction to the significance of capital in corporate finance and the challenges in managing capital structure decisions. The report delves into the core concepts of each theory, examining their assumptions, strengths, and limitations. The Trade-off theory is discussed in detail, including the balancing of benefits (tax shields) against costs (financial distress and agency costs). The Pecking Order theory is then explored, emphasizing the role of information asymmetry and the hierarchy of financing decisions. The discussion includes relevant graphs illustrating the Trade-off theory and the importance of internal financing. The report also addresses the impact of taxes and bankruptcy costs on capital structure choices, offering a thorough understanding of how companies make financing decisions. The conclusion summarizes the key findings and implications of these theories for corporate policy and strategy.

Running Head: MANAGING FINANCE FOR CORPORATE POLICY AND STRATEGY
MANAGING FINANCE FOR CORPORATE POLICY AND STRATEGY
Name of the Student
Name of the University
Author Note

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Table of Contents
Introduction................................................................................................................................2
Discussion..................................................................................................................................3
Capital Structure Theories’ Overview...................................................................................3
Trade-Off Theory...................................................................................................................3
Pecking Order Theory............................................................................................................6
Conclusion..................................................................................................................................9
Reference..................................................................................................................................11

2MANAGING FINANCE FOR CORPORATE POLICY AND STRATEGY
Introduction
Capital plays significant role in activities of the company. The competitive
environment of today has made managers cautious as well as more aware regarding the way
their business activities could be financed and capital structure could be managed. Capital
structure signified as most debatable concepts in the corporate finance. Majority of the
entities shows their concerns relating to capital structure as well as its decisions on the capital
structure, which is challenging for entity’s management. The reason behind this is capital
structure decision plays key role in business organization’s survival and any wrong decision
may results in financial distress of entities that leads to bankruptcy. Hence, decision
regarding company’s capital structure is most important decision confronting an entity in the
corporate finance. Further, decision-making of the capital structure is tactic, which is the art
for tackle down the complex situations (Yapa Abeywardhana 2017).
The capital structure is regarding financing the operations of business at the optimum
cost, which maximizes firm’s overall value. It is relative proportion of the equity and debt
that is used for financing the long-term funds sources used by companies. This include
common equity, debt and the preferred stock. There are different strategies that can be
employed for raising required funds, however most vital and basic financial sources are
shares, debt and retained earnings. The two major sources of company’s financing include
external and the internal financing. The external financing is referred to issue of debt or
equity and the internal financing source include retained earnings (Yulianto, Suseno and
Widiyanto 2016). Hence, this report aims to discuss two main theories of the capital
structure, which are Pecking order theory and Trade-off theory.

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Discussion
Capital Structure Theories’ Overview
‘Modigliani and Miller’ in 1958, firstly began the revolutionary work on the capital
structure in corporate finance field. The theory by MM states that in the perfect capital
markets, the leverage impact cannot be seen on the value of firm. It is because of this reason,
the theories propounded by MM is also termed as “The Irrelevance Theory”. This theory
documented that value of firm is not affected by ratio of debt to equity. However, in the real
world, structure of capital structure is relevant, which means, organization’s value is affected
by capital structure employed (Yang, Chueh and Lee 2014). Moreover, Myers in 1984
contrasted to the previous studies by saying that various theories of the capital structure does
not seems to explain the actual financing behavior and it appears to be presumptions for
advising companies on the optimum structure of capital, when one is so far from the
explanations of actual decisions. Later, it has been proved in one study that at financial
structure yielding lowest WACC, overall organization’s value is also maximized. This is
identified in study that correlation in between increase in value of organization can be
enhanced with the increased debt level (Thippayana 2014).
Further, there are various theories of capital structure highlighted in literature.
Generally, capital structure is managed by two most important theories, which are “Trade-off
theory” and “Pecking order theory”. The intensive research indicates that both the theories
plays dominant role in financing decisions of companies. Both theories have its own merits
and demerits (Shahar et al. 2015).
Trade-Off Theory
The most prominent theory of capital structure was Trade Off Theory. Myers in 1984
stated that by including the imperfections of market, entities seems to get the optimal value-
maximizing ratio of debt-equity with the help of trading off benefits of debt against any

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disadvantages. Hence, entities set the target ratio of debt and move gradually towards
achievement of goal. Trade off-theory is the oldest theory, which is associated with theory
from MM on the capital structure, which makes the emphasis on structure of optimum
capital. The main assumptions in MM theory is that there are no taxes. This theory suggested
that modified proposition of MM stress out advantage of the tax shield is counterbalance by
entity costs of agency cost and the financial distress. The achievement of optimum leverage
level is by the help of balancing benefits from payments of interest and cost of issuing debt
(Serrasqueiro and Caetano 2015).
Development of “trade-off theory” is of MM theorem takes into consideration effects
of costs of bankruptcy and taxes. The cost of bankruptcy is the cost incurred directly, after
there is perceived likelihood that company will default on the financing seems to be more
than zero. Further, example of the costs of bankruptcy is liquidation costs that helps in
representing value loss as outcome of the liquidating net assets of organization. The other
cost of bankruptcy is the distress cost, which is the cost incurred by organization, if it is
believed by shareholders that company will be discontinued. Moreover, financial distress and
theories of agency costs also assumes that the higher level of debts brings out financial
distress that ultimately bankrupt the entity or forced for going into restructuring or liquidation
of company. This explanation indicates that costs of the financial distress as well as
advantage from the tax shields gets balanced. Hence, entities having higher financial distress
cost would be having less debt in their structure of the capital (Mostafa and Boregowda
2014).
“V= V+PV-PV where V is firm, PV is interest tax shields and financial distress cost”

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Chart 1: Trade-off theory
“Trade-off theory” is considered as first step for development of the various other
theories that have studied the way entities chooses their capital structure. The theory of MM
can be used for explaining the way entities uses taxation for manipulating profitability and
choosing optimum level of debt. On the other side, level of the debt rises risk or cost of the
bankruptcy because as ratio of debt to equity increase, higher rates of interest will be required
by the debt holders and shareholders will be pretending higher profits for the investments
(RAZAK, HISYAM and ROSLI 2014). It is most often thought by the financial managers
regarding debt-equity decision of the organization as trade-off in between the interest tax-
shields and the costs of financial distress. Entities with safe tangible assets as well as
adequately the taxable income for shielding to have the higher target ratios. The entities that
are unprofitable with the risky intangible assets primarily relies on the equity financing.
Moreover, in the case of no costs to adjust capital structure, every entity needs to always be at
the target debt ratio (Rahman and Arifuzzaman 2014).

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There include various fundamentals for considering debt in the capital structure of
firm. Apart from the interest tax shield’s advantage, debt is having multiple benefits to
companies. The first benefit is that the debt is valuable device used by entity for signaling.
Research suggested that the leverage will increase value of entity because enhanced leverage
coincides with market’s value realization (Pontoh 2017). The second benefit is that debt will
reduce costs of agency related to the equity. These agency costs include problem of free cash
flow that is also known as problem of over investment. The third benefit is that debt reduces
management’s agency cost so that it helps in discipling the managers. However, details of the
debt limitations besides costs of bankruptcy as well as the financial distress includes that
managers acting in the shareholders’ interest may shifts the investment to the riskier assets
and incurring of costs are by holders of debt (Qureshi, Sheikh and Khan 2015). The second
limitation is that the managers might borrow still more as well as pays out to shareholders, as
the result of which debt holders suffers. The third limitation is that the excessive debts leads
to problem of the underinvestment or the problem of “debt overhang”. It means various good
projects could be passed on due to the fact that more level of debt cannot be issued at right
time because of existing level of debt (Martinez, Scherger and Guercio 2019).
“Trade-off theory” has been supported as well as criticized based on fact that this
particular theory is based on assumptions of the perfect knowledge in the perfect market. This
theory predicts that the highly profitable entities will be having higher levels of debt for
maximizing benefits of taxation and increase capital liability. Moreover, various studies have
conducted for proving that whether in reality entities follows trade of theory (Köksal and
Orman 2015).
Pecking Order Theory
Picking order theory has able to achieve noticeable importance in the descriptive
literature. Further, this major theory was developed by Myers in field of the corporate finance

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in relation to the capital structure. This is the alternative theory to the “trade-off theory”, in
which company is having perfect hierarchy of the financing decision. Main pillar of “Pecking
order theory” is information asymmetry. The theory of Trade-off does not consider
information asymmetry. However, this theory does not consider optimum structure of capital
or no target structure of capital. Further, apart from considering information asymmetry, it
also considers signaling effect. “Pecking order theory” was proposed by the “Myers and
Majluf” in year 1984. Further, they assume perfect market like MM (Güner 2016).
Figure 2: Pecking order theory hierarchy
Major factor that determines debt ratios levels includes demand and the supply
factors. However, decisions relating financing sources depends on preference order, which
includes internal finance, for instance retained earnings and reserves, equity and debts and
firms maximizes its values with the help of making choice for financing the new investment
with cheapest sources available (Chadha and Sharma 2015). The example of this is when
there are not sufficient internal funds for financing opportunities of investment then entities

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may or may not acquire the external financing and in case if it is done, then in that case they
are required for choosing among various external finances in such way that extra costs of the
asymmetric information is minimized. The hierarchy involved in the financing decision of
corporate is determined by the financing cost. This theory argues that the companies firstly
makes choice to employ the internal sources for financing project compared to arranging the
new debt or they prefer debt for issuing new shares (Berzkalne and Zelgalve 2014). If the
managers are acting in shareholders’ favor then they will not be issuing new undervalued
shares. In the equilibrium, company issues new the new stock only at the market down prices.
The new equity shares are issued by the managers in the hope to get offset by the NPV of
new opportunity of investment or growth opportunity. It leads towards drop in the price of
shares. Therefore, it is not good news for the assets in place. When there is increase in the
asymmetry of information, then issue becomes more worse. In order to make investment, the
companies with having more opportunity of growth are considered to be better in comparison
to the matured companies. This is because falling down of price is affected by the opportunity
value of growth compared to assets in place (Banerjee 2017).
Pecking order theory makes the assumptions that companies with having more
profitability will be issuing lesser debt and they are more likely to finance their activities with
the internal financing sources. The companies that are smaller with the more opportunities of
growth should issue less equity and more debt. Later, Mostafa & Boregowda cited in the
Myers 1984, came up with the “modified pecking order theory”. It was proposed by him that
company should take the benefit from filling the financial slack with issuing equity, in case,
when there is less asymmetry of information (Mostafa and Boregowda 2014). It is because of
this reason, the companies with some growth opportunities maintains low issue of the debt. In
some of the cases, organization’s value is reduced when more issue of the debt exceeds
capacity point of debt. Companies working near capacity point of debt, issues equity even

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when debt is preferable. It is because issuing debt, which exceeds capacity point of debt
reduces company’s value. Hence, based on this concept, it can be said that capacity point of
debt looks like target debt ratio that is mentioned in traditional approach of trade-off theory
of the capital structure (Adair and Adaskou 2015). The most significant way for identifying
the company that are following traditional approach of “trade-off theory” or the “pecking
order theory” is during time of IPO, in this it needs to check that whether entity has used all
its internal financing sources or not. In case, if all the internal sources are used for the
investment in new project by company, then it means that entity is following the pecking
order theory (Abbasi and Delghandi 2016).
Conclusion
Therefore, this report concludes that financial decision is vital for any entity. Both
pioneering theories, pecking order and the trade-off theories are not considered to be
mutually exclusive and few explanatory variables helps in obtaining optimal leverage ratio.
Further, trade-off theory states that for reducing taxable income, the profitable entities lean
towards issuing of more debt. Moreover, pecking other theory states that the profitable
entities try for reducing their level of debt according to rule that firstly internal funds should
be chosen and when there are not satisfactory retained earnings, then policies need to be
converted to the external financing.
Trade-off theory extensively explains capital structure and it does not possess much
limitations except the fact that there is negative correlation of profitability to debt. In
relations to this phenomenon, the theory of pecking order provides straight explanations that
limitations that there are mixed-proof in considering Pecking order theory itself. Hence, there
is requirement of more development for incorporating trade-off ideas as well as asymmetric
information in the future models that will be furnishing assumed as well as theoretical
outcomes for understanding complexities of the theories in better manner. Further, there are

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various empirical studies that have studied these theories, but researcher still not able to
identify the theory, which explains choice of capital structure in the best way. Many asserted
that theory of Pecking order better describes behavior of firm compared to traditional
approach of trade-off theory. Other researchers were having different opinions. Hence, there
are no universal theory of the choice of debt as well as equity and there should be no purpose
for expecting one. Yet, there are various valuable conditional theories that enables in
understanding financial structure, which is chosen by firm.

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Reference
Abbasi, E. and Delghandi, M., 2016. Impact of Firm Specific Factors on Capital Structure
based on Trade off Theory and Pecking Order Theory-An Empirical Study of the Tehran’s
Stock Market Companies. Arabian Journal of Business and Management Review, 6(2), pp.1-
4.
Adair, P. and Adaskou, M., 2015. Trade-off-theory vs. pecking order theory and the
determinants of corporate leverage: Evidence from a panel data analysis upon French SMEs
(2002–2010). Cogent Economics & Finance, 3(1), p.1006477.
Banerjee, A., 2017. Capital Structure and its determinants during the pre and post period of
recession: Pecking order vs. Trade off theory. Indian Journal of Finance (Scopus
Indexed), 11(1), p.44.
Berzkalne, I. and Zelgalve, E., 2014. Trade-off theory vs. Pecking order theory–empirical
evidence from the baltic countries. Journal of economic and social developmen, 1(1), pp.22-
32.
Chadha, S. and Sharma, A.K., 2015. Determinants of capital structure: An empirical
evaluation from India. Journal of Advances in Management Research.
Güner, A., 2016. The determinants of capital structure decisions: New evidence from Turkish
companies. Procedia economics and finance, 38, pp.84-89.
Köksal, B. and Orman, C., 2015. Determinants of capital structure: evidence from a major
developing economy. Small Business Economics, 44(2), pp.255-282.
Martinez, L.B., Scherger, V. and Guercio, M.B., 2019. SMEs capital structure: trade-off or
pecking order theory: a systematic review. Journal of Small Business and Enterprise
Development.