Question

1. Company A saved 1Billion dollars of internal cash in 2001 and 2002. Their debt to value ratio is around 40% in both 2001 and 2002. In order to finance a project in 2003, which costs 3 billion dollars, the company used 1billion dollar internal cash. The company had 3 billion dollars of internal cash before the project. The company’s cost of debt is the same as the cost of using internal cash. The market value of the company at the end of 2003 is 150 Billion dollars and the market value of equity is 90 billion dollars.

If you were told that the company is following pecking order theory, how would you evaluate the company’s decision in financing the new project?

If you were told that the company is following trade-off theory, how would you evaluate the company’s decision in financing the new project?

Answer 1

Pecking Order Theory: This theory states that the company should first try and finance new projects itself through retained earnings. In the internal source of financing is unavailable, then the company should finance the new project through debt. And finally, the company should finance the new project by issuing new equity as a last resort.

The order is important because it helps investors judge the company's health. If a company self finances a project that means it is strong. If a company finances through debt, it means that the company is confident about the project and that the company can meet the monthly obligations. Financing through equity is usually a negative signal, as the company thinks its stock is overvalued.

Now, according to the pecking order theory, the company financed $1 billion itself, while it could have financed the entire project itself. If the company decides to finance the remaining $2 billion using debt, then it will be a good decision according to pecking order theory. But if the company decides to finance the remaining amount via issuing new equity, its stock price can fall and it will be considered a bad decision according to the pecking order theory.

Trade-off Theory: This theory states that in a perfect market, the capital structure of the firm is determined by its earning potential and the risk of its underlying assets. Value of the company is independent of the method of financing used for new projects by the company.

Therefore, trade-off theory is neutral about the way company finances its new project.