Question

A firm that wanted to move to a higher debt ratio could offer to trade new debt for outstanding shares. A firm that wanted to move to a more conservative capital structure could offer to trade new shares for outstanding debt securities. What would be the stock price reaction to moving higher debt ratio by exchanging debt for equity? Explain using trade-off and pecking order theories of capital structure.

Answer 1

Trade off theory of capital structure will advocate that benefit associated with debt capital in the form of interest tax deduction & It should be balanced with the costs associated with debt capital in form of financial distress and they needed to be adjusted in order to select the best possible capital structure along with the equity capital.

Hence, the firm which wanted to move to more aggressive debt ratio is following the fundamental of trade off theory in which it is trying to maximize the overall optimum capital structure by use of debt capital.

Pecking order theory of capital structure will be advocating that internal modes of Financing should be used first in order to maximise the benefit associated with the internal financing and then the company should try to raise equity capital or debt capital from the market in form of external financing.

Exchanging of debt capital to equity capital can be having a NEGATIVE IMPACT on the SHARE PRICE because the company is trying to take more of the leverage and it can have a negative impact on the mindset of various investors.

Pecking order theory does not advocate for raising of equity financing as, it can only raise finance using pecking order theory if the all other means of Financing are exhausted.