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Difference between Capital Structure Theories

According to the Pecking order theory, managers are endowed with private information,

and they have incentives to issue risky securities, which are overpriced, while in the trade-off –

theory, managers can seek the capital structure, which is optimal. Trade-off – theory shows a

prediction between the assets risks, asset type, tax status, profitability, and average debt ratios,

but in Pecking order theory, there is no optimally well-defined debt ratio. In terms of variances,

the pecking order theory thoroughly explains the variance of debt ratios in contrast to the

tradeoff theory, which is based on the target adjustment model. Moreover, the Pecking order

theory can face rejection issues, in case finance flows with the target adjustment. However, on

the other hand, the trade-off theory works in such a case, but as a result, it creates debt ratios,

which are reverted (Elijah).

The main proposition of Trade-off –theory, states that capital structure is not relevant to a

firm’s value. The value of identical firms remains identical, and it is independent of financial

assets but depends on the expected future earnings. In contrast, the main proposition of the

Pecking Order Theory, states that a company must finance itself internally through retained

earnings, and if retained earnings are not available, then the company must finance through debt

(Evan). In terms of the debt ratio, the trade-off –theory suggests that if a firm’s ratios are lower

than the target ratio, the firm should adjust the debt upward, but if the firm’s ratio is higher than

the target ratio, a firm should adjust the debt downward. Similarly, in terms of the debt ratio,

pecking order theory suggests that if a firm has a positive free cash flow, then debt ratios that are
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below the target ratio must move away from the theoretical target, but if firms have a negative

free cash flow, then debt ratios which are above from the target ratio must move away from the

theoretical target (Silvia).

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References

Clark, Elijah. “Trade-off and Pecking-order Theories”. Elijah Clark, 2022.

https://elijahclark.com/trade-off-and-pecking-order-theories/

Tarver, Evan. “Which Financial Principles Help Companies Choose Capital Structure?”

Investopedia, 2021.

https://www.investopedia.com/ask/answers/052215/does-tradeoff-model-or-pecking-order-play-

greater-role-capital-budgeting.asp

Swinnen, Silvia. “CAPITAL STRUCTURE IN SMEs: PECKING ORDER VERSUS STATIC

TRADE-OFF, BOUNDED RATIONALITY AND THE BEHAVIOURAL PRINCIPLE”.

https://efmaefm.org/0EFMAMEETINGS/EFMA%20ANNUAL%20MEETINGS/2005-Milan/

papers/250-swinnen_paper.pdf