Question

2. (15 points) Compare the difference between MM proposition, trade-off theory, and pecking-order theory

Answer 1

All the above three theories MM proposition, Trade-off theory and Pecking-order theory is related to Capital Structure . Capital Structure refers to mix of capital or source of finance of a company. There are two types of source of finance to a company,

1. Internal Source such as retained earnings, and

2. External Source such as Debt etc.

The decision of capital structure of a company is a very important and Managers always look out for Optimal Capital Structure. An Optimal Capital Structure is a mix of capital having lowest weighted average cost of capital (WACC).

MM proposition, Trade-off theory and Pecking-order theory all three suggest optimal mix of capital but each theory have different approach.

Difference between these three theories about capital structure is provided in below table

	MM proposition	Trade-off theory	Pecking-order theory
1. Suggested by	Modigliani and Miller, two professors in the 1950s	Mayer in 1984	Donaldson in 1964 & modified by Mayer and Nicolas in 1984
2. Assumptions	No Taxes No transaction costs No bankruptcy cost Equivalence in borrowing cost for both company and investors Symmetry of market information, meaning company and investor has same information No effect of debt on company’s earnings before interest and taxes	Tax shield and cost of bankruptcy trade off each other.	Asymmetry of market information which means company has more information about return, risk etc than investors
3. Theory	MM propositions also called irrelevance theory of capital structure. This theory suggested the mix of capital has no impact on value of Firm and cost of capital. As interest payment has no benefits of tax therefore, ratio of debt and equity has no impact on WACC of company.	This theory suggest leverage has benefits of tax shields which means Debt is cheaper source of finance than equity as interest payment reduce the tax liability of company and thus reduce the WACC of the company. Company increase the proportion of debt in its capital structure until optimal capital structure reached. Here, optimal capital structure means when additional debt is not reducing WACC of company further, as it trade-off by present value of bankruptcy cost.	This theory suggests there are three types of source of finance- 1. Internal Source 2. Debt 3. New equity issue This theory guide how to hierarchy of choice of source of finance. Internal source is first preference and Debt is second and New equity issue is third preference for financing the company. Debt increase the overall risk of company and it has benefits of tax shield and New issue equity reduces the ownership right of existing shareholder. That’s why Debt and New equity is second and third preference for financing the firm.