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Pecking-Order and Trade-off Theories

Several theories are proposed to explain how companies deal with debt and financial distress.

QUESTIONS:

1. Compare and contrast trade-off theory and pecking-order theory.

2. Describe a specific business that seems to follow trade-off theory and another that follows pecking-order theory.

3. Why would these theories be more applicable in some industries than others?

Please include references.

Solution Preview

Several theories are proposed to explain how companies deal with debt and financial distress.

QUESTIONS:

1. Compare and contrast trade-off theory and pecking-order theory.

In finance there exist theories that attempt to explain how companies behave in respect to their funding sources. These theories include the pecking order theory and the trade-off theory.

The pecking order theory is a theory that asserts that companies will prioritize their funding sources. In finance they exists three broad sources of funds: equity, retained earnings and debt. Each source has its own costs which will be borne by the company.

The pecking order theory thus asserts that companies will adopt the least expensive source of funds as its first priority. This is normally the internal funds (retained earnings). After the retained earnings are fully utilized then debt will be acquired. At the point when the debt is no longer cost effective, the firm will then ...

Solution Summary

The solution discusses the pecking-order and trade-off theories.

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