Suppose the trade-off theory of capital structure is true. Can you predict how companies debt

QUESTION

Suppose the trade-off theory of capital structure is true. Can you predict how companies” debt ratios should change over time? How do these predictions differ from the pecking-order theory”s?
Answer: The capital structure of a company is how it finances its operations using debt and equity as the sources of funds. The major issue for every company is to have the right type of capital structure and decide what is the right combination of debt and equity that the company should hold so that it is able to minimize its overall cost of capital and maximize its market value. There are various theories that can help the firms in taking these decisions, one of them being the tradeoff theory. Trade off theory the theory states that the firm should leverage itself till the time it attains the optimal capital structure, which in simpler terms means that the company should finance itself using debt as it is cheaper than equity. The theory also recognizes the benefit the company will get in its tax payments due to deductions of interest on the debt. According to this theory the company will keep on increasing its capital from debt till the time it achieves a tradeoff between the lower cost of debt and the added financial risk. In real life, companies usually have lower debt ratio than the theory suggests being optimal. Change in debt ratio of the company over time If the theory is assumed to be true, the debt ratio of a company will increase over time, the company will finance more and more using debt till the time it has minimized its cost of capital. The pecking order theory this theory states that the company will use its retained earnings to finance its

ons, and when the retained earnings are not available, only then it will issue debt; the last resort for the company is issuance of equity. The theory is based on the viewpoint that issuing debt would send a message to the market that the management can pay off the interest on the debt, whereas issuing equity would mean that the company thinks its share prices are overvalued which can lead to a fall in the share prices. So under this theory of capital structure, the debt ratio of the company will be very low till the time the company has retained earnings to finance its operations and even after they are exhausted, the debt ratio wont increase drastically. The company will generate just enough debt to finance its operations. Comparison between both the theories: Under the trade off theory, the company has first preference to debt and the debt ratio is increased till the point the additional cost of debt is equal to the benefit of debt, whereas in pecking order theory the company has a preference for retained earnings, it will issue debt only when retained earnings are exhausted.

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