Corporate Finance Essay: Trade-Off vs Pecking Order Theories Analysis

This essay provides a comprehensive analysis of two prominent capital structure theories: the trade-off theory and the pecking order theory. The essay begins by explaining the trade-off theory, which posits that companies aim to find an optimal mix of debt and equity to minimize the Weighted Average Cost of Capital (WACC) while managing financial risk. It then delves into the pecking order theory, which suggests that companies prioritize internal financing (retained earnings) over external financing, and when external financing is necessary, they prefer debt over equity due to information asymmetry. The essay critically evaluates both theories, supported by empirical evidence from various studies, including those by Hardiyanto (2014), Leary and Roberts (2009), and Matemilola and Ariffin (2011). It highlights the contradictions between the two theories and concludes by emphasizing the need for financial managers to consider both frameworks when developing an optimal capital structure for maximizing returns. The essay also acknowledges the limitations and criticisms of both theories, offering a balanced perspective on their application in corporate finance.

ULSB Assessment Brief
MN3107 Corporate Finance

Introduction
The trade-off theory and pecking order theory are regarded as two major theories that are
used by a company for determining its optimal capital structure. The theories play an important
role in the decision-making process by financial managers for determining the optimal level of
debt in the capital structure of a firm for avoiding the occurrence of bankruptcy. In this context,
the present essay seeks to provide an explanation of trade-off and pecking order theory use by
companies for selecting an optimal capital structure.
Critical analysis of Trade off theory & Pecking Order Theory and choice of capital
structure
Trade-Off Theory
Jahanzeb (2013) has stated that the trade-off theory has been developed by Modigliani
and Miller for explaining the amount of debt and equity that should be maintained by a company
in developing its capital structure. It has been stated by the theory that a company can reduce its
Weighted Average Cost of Capital (WACC) by increasing the proportion of debt over equity in
its capital structure. This is because debt financing is cheaper as compared with the equity
financing. However, the increasing proportion of debt leads to rise in the financial risk present
within the company which can offset the benefits that it can realize by enhancing the amount of
debt. Hence, the theory seeks to define an optimal mix of debt and equity that should be
maintained by a company so that decrease in WACC offsets the financial risk present due to rise
in debt proportion.
The fact has been supported by Muneer (2012) and it has been said by the researcher that
the use of debt in the capital structure leads to reduce the cost of capital by achieving tax benefits
on its interest payments. In addition to this, it also helps in resolving the principal-agent problem
by restricting the free cash flows to the managers and thus resolving the agency conflict.
However, the theory has stated that excessive use of debt in the capital structure can lead to
causing financial distress within a firm when it is not able to meet its debt obligations. Therefore,
it is largely important to determine the optimal debt ratio that offsets the financial risk and leads
to maximizing a firm value.
Empirical Evidence for Depicting the use of trade-Off theory for Explaining the choice of
Capital Structure by Companies
In this context, the research findings proposed by Hardiyanto (2014) have proposed that
proportion of debt as a significant influence on capital structure of firms. In this context, the
researcher has adopted the use of partial adjustment model for providing the presence of
adjustment of selected companies from Indonesia towards achieving an optimal capital structure.
The data is gathered from about 228 companies of Indonesia with the use of regression
techniques. The model is applied to the data selected and it has been deuced that the companies

adjust their capital structure towards a defined target for gaining advantages of debt in the capital
structure. As such, the researcher has focused on developing a cost-benefit analysis that can be
achieved by developing an optimal debt ratio leading to maximizing a firm value. The optimal
proportion of debt can be determined when the benefits of using debt are able to overweigh the
financial risk that is present within a company due to debt obligations.
Consistent with the findings of the previous author stated that the researcher Leary and
Roberts (2009) has stated that firms tend to maintain target leverage ratio for obtaining the
advantage of debt and maximizing the value of their firm. In this context, the researcher ahs
carried a comparative analysis of the capital market based system and bank based financial
systems in five countries. It has been depicted by the result of the researcher that French firms
rapidly adjust to the leverage while Japanese firms are slow in adjusting towards a target
leverage ratio. On the contrary, Matemilola (2012) have suggested that there many factor that
determines the capital structure of affirm such as tax system or corporate governance in addition
to the amount of leverage. It has been revealed by the researcher that leverage ratio is negatively
related to the profitability of a firm and the performance of its stocks. As such, the researchers
has contradicted the views and opinions provided by trade-off theory to a large extent.
Pecking order theory
Pecking order theory has been derived to explain the capital structure and cost of capital
of the company. Julius, (2012), argues that pecking order theory has been successful in
explaining the difference in cost of internal capital (Retained earnings) and external capital (Debt
and equity). Pecking order theory reflects that due to information irregularity between the entity
and investors in regard to the real cost or values of current operations and future prospects, there
will always be difference between the cost of external capital and internal capital. Further this
theory has explained that external cost is relatively costlier than the internal capital due to
irregularity of information between investors and firm (Julius, 2012). In this context Zurigat
(2009), argued that issue of information irregularity leads mis-pricing of equity shares at the
market place that will leads to loss of return to the existing shareholders. It happens due to
improper selection issue that arises when managers are more knowledgeable as compared to
investors. It can be explained by an example related to use of outside capital as source of finance.
If any company finances its new venture or expansion plan through use of new issue of securities
than it is certain that price of such securities will be low as compared to price of old securities. It
is because initially managers cannot credibly provide the quality of the already existing assets
and available opportunities of investment to their new investors. As a consequence, investors
will not able to predict what is good or bad for their investment and they will definitely think that
company’s decision of issuing new securities is bad for them and they will not take part in such
securities. On the contrary investor will definitely demand for some premium on their investment
to cope with the loss of their investment but in reality it is not the case. This is the reason why,
companies have to issue the new securities at discount (Zurigat, 2009).

Gunarsih and Hartadi, (2017), provide a clear and important rationale regarding the
decision of financial policy of the firm and it is known as pecking order theory of capital
structure. As per this capital structure theory, firm tends to use internal sources of capital first
through adjusting the dividend payout ratio in light of investment decision taken by them. In
case, firm requires external capital due to the policy of fixed dividend policy, high fluctuations in
profitability position and there is high uncertainty regarding the investment opportunities that
managers will seek mostly of debt capital or hybrid capital such as convertible bonds and lastly
equity (Gunarsih and Hartadi, 2017). Further Gunarsih and Hartadi, has articulated that if cash
flow generated by the internal sources or business operations is greater that total outlays than
company will use extra funds to pay off the debt first or if market return is more than company
will invest its funds in capital market to earn more. As per this theory, business managers react
differently in different situation i.e. financial behavior of finance manager react differently for
surplus and deficits firms. This theory also provides that firm’s behavior upon the use of capital
also depends upon the transaction cost involved for financing the capital. Transaction is occurred
at the time of raising the external capital such as debt and equity (Gunarsih and Hartadi, 2017).
This theory has also faced many criticisms due to its underlying arguments and
suggestions. This theory has ignored other theories and impact of institutional factors that also
impact the choice of capital financing instruments such as level of interest rates relation of
borrower and lender etc.
Empirical evidence for choice of capital structure in UK market as suggested by pecking order
theory
Matemilola and Ariffin, (2011), have used the pecking order theory to test the capital
structure choice in UK market. The results gathered by this research shows that issue of new debt
capital does not have one to one relationship or direct relationship with the firms financing
deficit as per pecking order theory. In this case only 22% of financing deficit has been financed
with issue of debt capital (Matemilola and Ariffin, 2011).
Conclusion
It can be said for the overall discussion held within the essay that trade theory and
pecking order theory contradicts each other. Trade theory has determined positive relation
between the capital structure and amount of debt whereas pecking order has stated that a form
should finance itself from internal finance as compared with external. As such, it can be said that
financial managers need to implement the use of both the theories in developing an optima
capital structure for deriving lager returns on the capital employed.

References
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Hardiyanto, A. 2014. Testing Trade-Off Theory of Capital Structure: Empirical Evidence from
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Jahanzeb, A. 2013. Trade-Off Theory, Pecking Order Theory and Market Timing Theory: A
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Julius, A. 2012. Pecking Order Theory of Capital Structure: Another Way to Look At It. Journal
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Leary, M.T. And Roberts, M.R. 2009. Do Firms Rebalance Their Capital Structures? Journal of
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Muneer, S. 2012. A Critical Review of Capital Structure Theories. Information Management and
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Zurigat, Z. 2009. Pecking Order Theory, Trade-Off Theory and Determinants of Capital
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http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.465.8550&rep=rep1&type=pdf
[Accessed on: 4 April 2019].