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Trade Off Theory and Pecking Order Theory

Based on Trade Off Theory and Pecking Order Theory, discuss how the optimal mix of debt and equity in capital structure is attained where there is a trade-off between the expected benefits and costs of debt financing.
- Compare Pecking Order Theory and Trade Off Theory
- How do Pecking Order Theory and Trade Off Theory relate to optimal leverage?

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The main objective of any firm is maximizing shareholders' wealth. For this there are several issues which are determined and have to be managed by reaching a point of optimal capital structure. As a result, financial managers thrive to attain an optimal mix of equity and debt in the firm's capital structure. There are various theories which help answer the issues related with finding an optimal mix. Two such theories are trade-off theory and pecking order theory.

According to the trade-off theory, the weighted average cost of capital initially decreases as more debt is added to the capital structure due to tax advantage of acquiring debt. At a certain point of financial leverage, the tax benefit will no longer be sufficient to cover the rising costs of debt and equity. Past a certain debt ratio, the market will demand higher interest rate and cost of equity as the market perceives that the firm's risk of bankruptcy is increasing because of the firm's rising debt load (Gardner, John C., McGowan, Carl B., Moeller, Susan E. 2010). At this point, the firm's WACC starts increasing. At the point where a firm's WACC is minimized, the firm's value is maximized. According to trade-off theory, companies are expected to look for target debt ratios. Managers make capital structure decisions with the objective of maximizing the total value of the levered firm. Optimal structure is defined as the debt value that maximizes the total levered value of the firm. According to ...

Solution Summary

The trade off theory and pecking order theory is examined.