TRADEOFF THEORY:There are two costs which are as follows: I. II. Financial distress Cost. Agency Cost.

Financial distress Costs: It can lead the firm to bankruptcy. When a firm experiences financial distress it leads to many effects mentioned below: a. Arguments between shareholders and creditors delay the liquidation of assets. b. Under stress situation assets do not get the deserving value for it. c. The legal and administrative cost in case of bankruptcy is high. d. Survival in the short run becomes the priority, as financial stabilization is the need of the hour. Managers plan for the short term goals, payments to creditors may stretch and may hinder the goodwill. e. Due to delay in payment may dilute the commitment on the part of suppliers. Also the employees and investors may lose faith in the company. First three effects are the direct cost to the firm while the rest two are the indirect cost to the firm. The major contributor of this situation is debt. Greater the level of debt, larger is the debt servicing burden and higher the probability of financial distress.

Agency Costs: An agency cost is an economic concept that relates to the cost incurred by an entity associated with problems such as divergent management-shareholder objectives and information asymmetry. Agency costs mainly arise due to divergence of control, separation of ownership and control and the different objectives. When a firm has debt, conflicts of interest arise between stockholders and bondholders. Because of this, stockholders are tempted to pursue selfish strategies, imposing agency costs on the firm. These strategies are costly, because they lower the market value of the whole firm. Other problem faced is the moral hazard on the part of the creditors, when they lend to a firm having large outstanding debt. Managers redeploy the assets of the firm in such a way that it actually diminishes the value of the firm.

Effect of Financial Distress and Agency Costs: Value of the levered firm = Value of the unlevered firm + Tax advantage of debt. When debt increases, financial distress and agency costs would cause the value of the levered firm to decline. Tradeoff theory states that every firm has an optimal debt-equity ratio that maximizes its value. The optimal debt-equity ratio of a profitable firm that has stable, tangible assets would be higher than the optimal debt-equity ratio of an unprofitable firm with risky, intangible assets, because a profitable firm can avail of tax shelter associated with debt fully.

SIGNALING THEORY: In 1961, GORDON DONALDSON, examined how companies actually establish their capital structure. Following are the inferences from the theory: a. Firms rely on internal accruals. b. Expected future investment opportunities and expected future cash flows influence target dividend payout ratios. c. Dividends are raised only when the firm is confident that the higher dividend can be maintained, dividends are not lowered unless things are very bad. d. If a firm’s internal accruals exceed its capital expenditure requirements, it will invest in marketable securities. e. If a firm’s internal accruals are less than its non-postponable capital expenditure, it will first draw down its marketable.

There are following scenarios in this theory: Scenario I: Asymmetric information is resolved before the equity issue. New share price = (Original market value + New money raised + NPV of the project)/ (original shares + New shares) Scenario II: Asymmetric information is resolved immediately after the equity issue. New share price = (Revised Market Value + New Money Raised + NPV of the project) / (original shares + New shares)
Scenario III: Asymmetric information is resolved immediately after the equity issue but the

proposed project has a higher NPV.
New share price = (Revised Market Value + New Money Raised + NPV of the project) / (original shares + New shares)

Scenario IV: The original project is financed with debt. New share price = (New Market Value + NPV) / (Original Shares) Scenario V: Management believes that the firm has bleak prospects which are not reflected in

share prices. New Intrinsic Value = (Old Intrinsic Value + New Money) / (Original Shares + New Shares)

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