Question

Discuss what may lead to a breakdown of the Modigliani-Miller irrelevance theorem, and give an overview of the trade-off theory and the pecking-order theory of capital structure.

Answer 1

The irrelevance theory of Modiglani Miller states that the capital structure of a company is irrelevant if the distressed costs and income ax is not present.

This theory lacks reality because in real life we do not encounter a situation where there is no taxes and no transaction costs. This leads to the breakdown of the irrelevance theorem.

Trade-off theory :Hoe much should the company be financed with debt and equity by balancing the cost and benefits .

with debt comes the risk of costs of financial distress and as well as the benefits of interest tax shield.

A major assumption made in Pecking order theory is asymmetric information.  Asymmetric information captures that managers know more than investors and their actions therefore provides a signal to investors about the prospects of the firm.

Although debt is cheaper, debt can come along with a lot of costs like the costs of bankruptcy.So there is a pecking order for raising finance for the business:

Pecking order theory :Financing comes first from retained earnings, debt, short term securities, preference capital and at the last comes common stock.