8th December , 2013
He initiates the discussion with the first theory on capital structure i.e Static Trade Off theory, where he used a diagram to explain as how the finance managers are often viewed as trading off the tax savings from debt financing against cost of financial distress, specifically the agency costs generated by issuing risky debt and the deadweight cost of possible liquidation and re-organization. In other words, the tax deductibility of interest payment induces the firm to borrow to the margin where the present value of interest tax shields is just offset by the value loss due to agency costs of debt and the possibility of financial distress. He commented that Static Trade Off theory has several things in its favor. First, it avoids ‘’corner solutions’’ and rationalize modern borrowings with a notion that borrowing indeed saves taxes and too much debt can lead to financial distress. Secondly, closer analysis of costs of financial distress gives a testable prediction from the static trade off theory; since these costs should be most serious for firms with valuable intangible assets and growth opportunities.
Although, Static Trade Off theory is supported even by academicians and other emperical studies and these studies could be interpreted as proving investors appreciation of the value of interest tax shields, thus confirming the practical importance of the static trade off theory. However, on the other side this evidence works against the stratic trade off theory as the competing theory of pecking order , can explain same facts as the markets rational response to the issue or retirement of common equity; even if the investors are totally indifferent to changes in financial leverage. Also, a simple stratic trade off theory could not even predict of what was found by even studies. Thus, on these basis we can say that this theory is not a complete theory and we could expect to observe some firms issuing debt and retiring equity to regain the optimum debt/equity ratio while the other firms would be using less debt and moving to equity.
Moving further, author now explains the Pecking Order Theory of capital structure under which there is no set debt equity ratio. The attraction of interests tax shield and the threat of financial distress are assumed to second order and gives an immediate explanation for the negative intra-industry correlation between profitability and leverage. The theory also explains why stock price falls when equity is issued and if the firm acts in the interests of its existing shareholders, the announcement of equity is always a bad news. Similarly, a debt for equity exchange is good news just because it causes repurchase of equity. Thus, the pecking order theory explains why equity issues reduces when stock price but plain vanilla does not. Thus, a pecking order theory would predict a small negative impact when a debt issue is announced, but for most public issues the effect of pecking order theory should be very small and likely to be lost in the noise of the market.
Finally, he concludes that none of these two theories is complete and satisfactory, although it is only pecking order theory is a serious contender which asserts symmetric information as chief underlying problem.
Works Cited
Myers, S. Still searching for Optimum Capital Structure. In Risk Management (pp. 142-154). Massachussets: Massachussets Institute of Technology.
