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Managers know more about the true value of the firm and the firm¶s riskiness than less informed outside investors. To avoid the underinvestment problem, managers will seek to finance the new project using a security that is not undervalued by the market, such as internal funds or riskless debt. Therefore, this affects the choice between internal and external financing
THE PECKING ORDER THEORY
The pecking order theory describes how firms raise capital. This theory says that firms are driven by information asymmetries and transaction costs to use internally generated capital first before turning to more expensive sources of financing. Once their internal sources are used, then firms will use debt (where the information asymmetry problem is less severe) first and then as a last resort equity.
The pecking order theory is able to explain why firms tend to depend on internal sources of funds and prefer debt to equity if external financing is required. Thus, a firm¶s leverage is not driven by the trade-off theory, but it is simply the cumulative results of the firm¶s attempts to mitigate information asymmetry.
As per Myer¶s Pecking order theory firm will take debt in which they have to give least information to the market
Order 1. 2. 3. 4.
Retained Earning Private debt Public debt Equity
The Static Trade off theory -: Deals with the cost of distress and positive effects of tax D/V optimal when Marginal Benefit of tax shield are not greater than marginal cost of bankruptcy.
or PV (Tax Shields) = PV(Expc Bankruptcy Costs) Using High leverage in the capital structure cannot be explained.
The static tradeo¤ theory of optimal capital structure assumes that Þrms balance the marginal present values of interest tax shields against the costs of Þnancial distress.
Singalling theorey By raising public debt companies provide signal to the market that there are many investors and project is good .