Question

the static-tradeoff theory and the pecking order theory. Do you think either theory represents how capital structure decisions are made in practice? If so, which theory is more closely aligned with CFO actions? If not, what do these theories fail to capture about the actions of financial managers.

minimum 300 words

Answer 1

The capital structure is the mix between the equity, debt and the revenue component that a firm uses to fund growth and operations. The mix between the equity and capital maybe such that the cost of capital is minimized and the value of the firm is increased. There are basically three theories the net income approach theory, the static trade-off theory more commonly known as MM theory devised by Modigliani and Miller hence the name MM and the Pecking order theory.

The Static Trade-Off theory

Devised by economist Modigliani and Miller in 1950s. The theory suggests that a value of a firm is independent of the capital structure under certain assumptions namely

1) this theory applies in perfect market competition where the investors are free to buy and sell securities. other assumptions in perfect market includes that there are no transaction cost, the investor and the company borrow on the same terms and investors are rational and well informed.

2) the business risk of all the firms is same

3) the investors have the same expectations about the net operating income.

4) the dividend payout ratio is 100%

5) personal leverage and corporate leverage is equal

6) there are no corporate taxes

the static trade-off theory describes the relationship between capital structure, cost of capital and value of the firm on 2 propositions

proposition 1- the overall cost of capital and value of the firm are independent of the capital structure of the firm. this means that the value of the levered firm using debt and value of the un-levered firm which does not use debt is equal.

proposition 2- as the firm introduces debt the cost of equity increases as risk increases because of the increase in debt. This offsets the lower cost of capital that is debt. hence the net effect is same even if the firm uses debt or equity to fund itself.

conclusion of static trade-off theory-

1) the value of the firm is not affected by its capital structure (under no tax applicability)

2) cost of capital in case of levered or unlevered firm is same and is equal to the cost of equity

3) there is no optimal capital structure. The value of the firm and the overall cost of capital in case of levered and unlevered firm  is same.

Pecking order theory

The pecking order theory suggests that the firm should use its retained earnings to finance, then it should give second priority to debts and lastly when the firm has no alternative finance then it should use equity as the last resort to finance. If a firm is able to finance itself internally that is through retained earnings then it signals that the firm is internally strong. If the firm uses debt as the source it signals that the firm is confident in its operations and can meet the monthly obligations. if a firm uses equity as a source of finance it usually signals negativity to the investors, as it is likely the firm thinks its stock are overvalued and the firm is trying to make some extra money before the share prices start dropping.

Companies normally prefer using the pecking order theory because of the drawbacks of the static trade-off theory, which are

1) unrealistic assumptions, the static order theory is applicable only in perfect market which is quite unrealistic. Also the theory fails if taxes are introduced and taxes are there in the general world.

2) the corporate leverage and personal leverage are not same in realistic world as the terms and conditions for personal and corporate leverage is different.

3) in the real world there is some degree of transaction cost involved in case of buying and selling of securities

Because there are so many drawbacks involved with the static trade-off theory the cfo cannot closely align with this theory. but is should be noted that in the real world companies cannot blindly follow a single theory even if its the pecking theory. the CFO needs to understand the benefits of each theory and then devise a capital structure and not solely rely on one theory.

(you can also use graph to explain the relation between the cost of capital cost of equity and value of firm to make the answer more presentable)

If you like my efforts and are satisfied please give a thumbs up.