Question

What're the assumptions of Trade-off theory and the Pecking order theory, please lits all. thank you

Answer 1

The trade-off-theory is based on the assumption that the firm has to balance the benefit arising out of the tax shield because of the debt and cost arising out of the bankruptcy. The major cost associated with financing capital with debt is obliation to meet the cost of debt and other non-financial distress like company Image, its creditworthiness, employee satisfaction all taking a hit. The trade off theory is based on the assumption that firm should balance their debt to capital in such a way that cost arising out of financial distress does not outweigh the benfits associated with tax shield.

The pecking order theory is based on the assumption of assymetric Information:

• There is no target capital structure that companies follow.
• Manger of the company have more information and they use it to raise funds to their advantage. For example, compnaies go for raising money through equity when they believe their share price is overvalued.
• Firms plan their funds raising with the first being least resistant, they prefer Internal financing first and they go for debt and at last they go for equity.