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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 doesnt go for 100% debt. Financial expenses include two things one is bankruptcy cost and other is 4/23/12

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. Optimal capital structure is effected by taxes, cost of financial distress, and agency cost. If firm choice debt for their financing 4/23/12 than debt save tax for it but on the

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

CRITICISM

The tradeoff theory hypothesizes leverage is beneficial until a firm reached optimal capital structure. When optimize level is gained leverage has no more importance. But there are many companies that have small leverage than this theory suggestion.
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Pecking Order Theory

It asserts that organization order their sources of financing. 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. 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, security issuance costs, 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.

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 firms 4/23/12 value so conflict arise among them

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. In case project is profitable shareholder get benefit as firm value increase, but if project fail then all lose has to bear by debt holder. It will possibly decrease organization value 4/23/12 and equity holder receives all benefit.

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. The thing that effect is time at the time of investment firm should select best suitable source of financing. 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