Corporate Finance
Deciding the appropriate capital structure of the company is an important decision and it relates to finding the best combination of debt and equity in such a way, so it maximizes the market value of the firm. Eminent Researchers, Modigliani and Miller have contributed at large in proposing two of theories relating to conceptualization of capital structure, namely, Trade Off Theory and Pecking Order Theory.
Trade Off Theory: The theory asserts that as Debt financing allows deduction of interest cost associated with it, it is relatively cheaper source of finance for the company and because it do not lead to dilution of ownership and can be collateralized, firm can benefit from debt financing by lowering its Weighted Average Cost of Capital(WACC). However, since debt financing increases the risk of financial distress, a firm must balance the benefit brought by lower WACC against the increase in financial risk. In short, trade off theory identifies the optimum debt-equity ratio as the level at which the two offset each other.
Pecking Order Theory: This theory asserts that a firm always prefer to finance their operations with retained earnings and then only move to debt financing. The decision to issue equity is the last preference for the company. As per the theory, firms carry such attitude because of the type of message that different type of securities send to the market. For Instance, raising debt financing assures market that the firm is confident that it can honor debt obligations, while, equity financing signals that management is targeting fall in share price. In short, this theory analyses includes agency theory and describes the financing decisions as being affected by market sentiments where minimal supervision from shareholders is desired by the management.
ii) Various researchers have proved that Software Industry has been actively relied on Trade Off Theory while high profit margins industry i.e Pharmaceutical Industry relies on Pecking Order Theory
iii) These theories are more applicable in some industry than other because of its core objective i.e since pecking order theory prefers retained earning financing, it is more prevalent in High Profit Margin companies which have enough internal funds to finance their operations. Similarly, trade off theory is prevalent in manufacturing industries that rely heavily on debt to finance their operations
Works Cited
Capital structure: trade off theory vs. pecking order theory. 6 January 2012. 22 February 2014 <http://ablogaboutfinance.wordpress.com/2012/01/06/topic-5-capital-structure-trade-off-theory-vs-pecking-order-theory/>.
Labba, Johanna. "Testing Pecking Order and Trade Off Theory." Research. 2009.
