Question

how companies handle debt and equity using the trade-off and pecking-order theories of capital structure?

Answer 1

Trade-off theory states that a company tries to create a balance between costs and benefits associated with financing from debt funds and equity funds. There are advantages such as tax benefits arising out of debt financing but there are also corresponding costs/risks such as agency costs and risk of bankruptcy associated with debt funds. These costs of debt funds make equity funds a viable alternative to the company. So, the trade-off theory talks about analysing these costs and benefits of the debt funds versus that of equity financing and evaluate an optimal capital structure necessary for the company.

Pecking order theory, on the other hand talks about the order in which companies can sources financing for operations. According to the pecking order theory, the order/flow of sources of finance for a company should be starting from internal financing sources and then moving on to external financing sources, first from debt and then lastly exploring external equity financing option. Thus, pecking order theory provides with a path for sourcing funds needed by the company.

In conclusion, trade-off theory can be used to determine the optimal capital structure, that is, the break-up between debt and equity funds. Following this, a pecking order theory can be used to identify the appropriate sources of required for financing.