Question

In: Finance

Empirical evidence shows that highly profitable firms tend to have lower debt ratios (debt to equity,...

Empirical evidence shows that highly profitable firms tend to have lower debt ratios (debt to equity, debt to total capital, debt to assets, etc.). Briefly explain if this evidence supports or does not support the trade-off theory of capital structure. Also, briefly explain if this evidence supports or does not support the pecking order theory of capital structure.

Solutions

Expert Solution

Highly profitable firms tend to have lower debt ratios. This evidence supports the trade off theory of capital structure. The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. There is an optimal amount of debt which the company can hold which maximises the value of the firm. Hence, if a company has low debt and it goes under financial distress, it can always issue more debt. If they have less debt, they will be under the optimal amount of debt and increasing the debt at the time of distress will only increase the value of the firm. Whereas, in case of a highly levered firm, at the time of distress, if they issue more debt their firm value is going to decrease. Hence, they wouldn't have the liberty to issue more debt.

The evidence given in the question does not support the pecking order theory of capital structure. This is because the pecking order theory states that a company should prefer to finance itself first internally through retained earnings. If this source of financing is unavailable, a company should then finance itself through debt. Finally, and as a last resort, a company should finance itself through the issuing of new equity. So, if this was true, successful companies should have been more and more levered and would have more debt than equity because debt is more cheap. But, this is not so. Hence, pecking order theory can't be explained by this statement.


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