Why should a public corporation ever have to land in financial distress?

QUESTION

The trade-off theory relies on the threat of financial distress. But why should a public corporation ever have to land in financial distress? According to the theory, the firm should operate at the top of the course market movements or business setbacks could bump it up to a higher debt ratio and put it on the declining, right-hand side of the curve. But in that case, why doesn”t the firm just issue equity, retire debt, and move to back up to the optimal debt ratio? What are the reasons why companies don”t issue stockor enough stockquickly enough to avoid financial distress?
The trade off theory proposes to explain market leverage leverage. The weight of debt in the capital structure with chanages in market value of its components. When the debt ratio increases and the company is in a declining, the firm issues new equity in this condition to make up for the debt and then the equity shareholders will anticipate a higher business risk associated with their investments. Hence they will be reluctant to purchase equity shares. Again, if the equity shares are purchased

that they would expect a higher dividend which would ultimately increase cost of equity and then resulting to increase in the overall cost of capital of the company. Hence the firm would ask for more problems if new it issues new stocks when its is in financial distress. Rather the company should go for private placement of shares.

ANSWER:

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