Question

After researching, explain the trade-off theory and the pecking order theory using your own words. Do you see any evidence of pecking order theory in the company (Best Buy) you are analyzing?

Answer 1

Both concepts are really simple. Just try and understand the basic motive of both the theories

Trade Off Theory: The belief behind this theory is debt is less priced and more economical than equity. Cost of equity is more than the cost of debt because of the tax benefit. And when we take more and more debt our WACC decreases. So MM (Modigillani Miller) suggested that company should take more and more debt. But there comes a point where the tax benefit is no more profitable that means it doesn't matter. And after that cost of debt starts increasing because increased gearing comes with increased risks, interest costs.

Also, in practical life, companies tend to take less debt in comparison to suggested by the theory because of the risks and interest charges.

Pecking order theory= This theory contradicts the static trade off theory. This simply suggests that firms don't look for an optimum capital structure rather they raise funds as follows:

1. Internally generated funds (Retained earnings or Residual savings)

2. Debt

3. New share issue

Debt financing may be preferred where the maturity of debt can be matched to the expected life of investment project. Equity finance is is permanent finance and so may be preferred for investment projects with long lives.