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Tradeoff Theory of Capital Structure

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4/23/12

Tradeoff Theory of Capital Structure • This theory came forward for explaining MM proposition 2 that a company can get optimal capital structure by have 100% debt. but company has agency cost and financial distress cost due to which a corporation doesn’t go for 100% debt. Financial expenses include two things one is bankruptcy cost and other is 4/23/12 • .

and agency cost.Static Trade-Off Theory • Tradeoff theory (also known as tax base theory) refers as choosing of debt and equity in such a way that it will balance expense and advantages of debt. If firm choice debt for their financing 4/23/12 than debt save tax for it but on the • • . cost of financial distress. Optimal capital structure is effected by taxes.

Dynamic Trade-Off Theory • This theory explains effect of time on leverage instead of constructing single-period model of optimal capital structure construct dynamic model. Dynamic model have ability to explain many aspect on which static trade-off theory does not has pay attention such as expectation and adjustment of cost. 4/23/12 • .

But there are many companies that have small leverage than this theory suggestion. When optimize level is gained leverage has no more importance.CRITICISM • The tradeoff theory hypothesizes leverage is beneficial until a firm reached optimal capital structure. 4/23/12 .

Firstly retain earning (internal financing) is utilized when it consumed than debt announce and at last when this is not reasonable to issue more debt equity is issued.Pecking Order Theory • It asserts that organization order their sources of financing. The pecking order theory familiarizes by Myers (1984) present that equity is less preferable way of increasing 4/23/12 • .

CRITICISM • Pecking order theory is not explaining the impact of taxes. financial expense and Agency costs. It also omit the problem of too much financial slack that exempt firm from market discipline. Due to these short come this theory had done some addition in explaining capital rather than becoming replacement of 4/23/12 previous theory. security issuance costs. .

Agency Costs Theory • Jenson and Meckling (1976) explain agency cost and said there is mainly two type of conflict. Jenson and Meckling (1976) explain agency cost and said there is mainly two type of conflict. Manger has desire to maximized their own interest where as shareholder want to maximize firm’s 4/23/12 value so conflict arise among them • • .

. It will possibly decrease organization value 4/23/12 and equity holder receives all benefit. but if project fail then all lose has to bear by debt holder. In case project is profitable shareholder get benefit as firm value increase.Agency Costs Theory • • There is three type of agency cost Asset Substitution Effect Leverage is going to increase than firm will also go for negative NPV project.

The thing that effect is time at the time of investment firm should select best suitable source of financing.The Market Timing Hypothesis • Wurgler and Baker firstly present it in 2004. They said that if a firm is finance by debt or finance by equity it does not affect. New equity is issued when stock price is overvalued and equity is purchased back by firm when perceiving stock 4/23/12 price to be undervalued. These .