Tradeoff Theory of Capital Structure

Tradeoff Theory of Capital Structure

• This theory came forward for explaining MM proposition 2 that a company can get optimal capital structure by have 100% debt, but company has agency cost and financial distress cost due to which a corporation doesn’t go for 100% debt.

• Financial expenses include two things one is bankruptcy cost and other is non-bankruptcy cost. A common example of a cost of financial distress is bankruptcy costs. These direct costs include auditors' fees, legal fees, management fees and other payments. Cost of financial distress can occur even if bankruptcy is avoided (indirect costs).

Static Trade-Off Theory• Tradeoff theory (also known as tax base theory) refers as

choosing of debt and equity in such a way that it will balance expense and advantages of debt.

• Optimal capital structure is effected by taxes, cost of financial distress, and agency cost.

• If firm choice debt for their financing than debt save tax for it but on the other hand financial expenses has to bear by firm.

• If firm carry on using more debt than cost of debt that is financial distress going increase and lowered debt benefit.

• A firm performs trade-off activity among debt and equity in order to reach optimal capital structure

Dynamic Trade-Off Theory• This theory explains effect of time on leverage instead of

constructing single-period model of optimal capital structure construct dynamic model.

• Dynamic model have ability to explain many aspect on which static trade-off theory does not has pay attention such as expectation and adjustment of cost.

• Dynamic model depend on financing margin that is the firm participate in next period. Some firm look forward to give out funds in next period, although some firm want to increase funds. If firm want to increase funds they take it either from debt or equity or use both.

CRITICISM

• The tradeoff theory hypothesizes leverage is beneficial until a firm reached optimal capital structure. When optimize level is gained leverage has no more importance. But there are many companies that have small leverage than this theory suggestion.

Pecking Order Theory

• It asserts that organization order their sources of financing. Firstly retain earning (internal financing) is utilized when it consumed than debt announce and at last when this is not reasonable to issue more debt equity is issued.

• The pecking order theory familiarizes by Myers (1984) present that equity is less preferable way of increasing capital. Announcing new capital give perception that organization is overvalued and as return investors appoint less financial worth to new equity.

CRITICISM

• Pecking order theory is not explaining the impact of taxes, security issuance costs, financial expense and Agency costs. It also omit the problem of too much financial slack that exempt firm from market discipline. Due to these short come this theory had done some addition in explaining capital rather than becoming replacement of previous theory.

Agency Costs Theory

• Jenson and Meckling (1976) explain agency cost and said there is mainly two type of conflict.

• Jenson and Meckling (1976) explain agency cost and said there is mainly two type of conflict.

• Manger has desire to maximized their own interest where as shareholder want to maximize firm’s value so conflict arise among them and in order to check manager act shareholder done some action some cost is attached with these action and this cost is called agency cost.

Agency Costs Theory• There is three type of agency cost• Asset Substitution Effect Leverage is going to increase than firm will also go for negative NPV project. In case project is

profitable shareholder get benefit as firm value increase, but if project fail then all lose has to bear by debt holder. It will possibly decrease organization value and equity holder receives all benefit.

• Under investment Problem When debt is hanging by a thread mean risky or uncertain then debt holder than shareholder

receives benefit of project. Management reject positive NPV project even positive NPV project add value to firm value. Management is trying to increase the equity rather than increasing value of firm.

• Free Cash Flow After financing all projects having positive NPV cash flow left over is called free cash flow. This

left over cash flow does not utilized optimally by the mangers that have fewer stakes in firm. They used it in their own interest rather than increasing firm overall value. Increasing debt create problem for management.

The Market Timing Hypothesis

• Wurgler and Baker firstly present it in 2004. They said that if a firm is finance by debt or finance by equity it does not affect. The thing that effect is time at the time of investment firm should select best suitable source of financing. New equity is issued when stock price is overvalued and equity is purchased back by firm when perceiving stock price to be undervalued. These fluctuations of stock price effect.