Question

What are some key differences associated with the trade off theory and the pecking order theory and how does the economic climate play a role in each theory?

Answer 1

The static trade of theory is given by economist Modigliani and Miller. It is based on the idea that debt financing is cheaper as compared to equity financing.The debt payment made by company is tax deductible so taking debt is less risky as compared to use of equity.his means a company can lower its weighted average cost of capital (WACC) through a capital structure with debt over equity. However, increasing the amount of debt also increases the risk to a company, somewhat offsetting the decrease in the WACC. This theory highlights the use of mix of debt and equity. This means that decreasing WACC offsets the increasing financial risk to a company.

The pecking order theory highlights the order in which a company should finance itself. First of all a company should finance itself from retained earnings. This means that company is strong internally and it gives a positive image about the company to investors. Secondly the company should finance itself through debt if it does not has sufficient retained earnings. This means that management is confident that company can meet its daily obligations. As a last resort company should finance itself by using new equity.If a company finances itself through issuing new stock, it is normally a negative signal, as the company thinks its stock is overvalued and it seeks to make money prior to its share price falling.

Factors that affect these theories are very country specific. It depends on the factors like corporate governance, corporate and personal tax system, law & regulations, development of the capital and debt markets, etc which are highly economy specific.This shows that the economic environment has a great impact on financing decisions and capital mix and thus the influence of macroeconomic indicators such as inflation or interest rates should also be considered.

Size has a positive influence on debt, so listed companies can access more debt when they have a good reputation on the financial market. There is also some evidence that larger listed firms access less long-term debt, preferring short-term funding. While the positive correlation between size and debt is an assumption of the trade-off theory, the negative one refers to pecking order model. In cross-country analysis, it was proved that the larger the companies are, the less liability they owe, following the former theory. However, these results were not consistent in all the single country studies.