Financial managers of companies are responsible for a much larger operation when

they manage corporate funds. They are responsible for financial decisions which
can divided into the following three:
Investment decision
Financing decisions, and
Dividend decisions
The financing decision addresses the problems of how much capital should be
raised to fund the firm`s operations and what the best mix of financing is. That is,
at what proportion of financing should be debt and what proportion should be
equity that will optimized the firm`s wealth. Management is supposed to identify
the capital structure that maximize the firm value and may resort to various means
of external funding. This prompted the concept of an optimal capital structure,
which maximized company value.
Debt financing requires payback with cash flow commitments that are independent
of the successful use of the money borrowed. Equity financing is less risky as
regards cash flow commitments, albeit it dilutes share ownership, control and
earnings. The cost of equity is higher than the cost of debt that is a deductible
expense. Hence, trade-off theory (TOT) assumes that firms choose how to allocate
their resources comparing the tax benefits of debt with the bankruptcy costs
thereof, thus targeting an optimal debt ratio. Pecking order theory (POT)
challenges the former theory, contending that firms prefer a sequential choice over
funding sources: they avoid external financing if they have internal financing
available and avoid new equity financing whenever they can engage in new debt
financing.
The aim of this preparation is to compare and contrast which of the two major
theories of capital structure (Trade-Off Theory (TOT) or Pecking Order Theory
(POT)) provides the best predictions as regards the borrowing behavior of
companies. We start by briefly introducing these two concepts and then make the
comparison of two the theories.
Trade-off Theory (TOT): taxation, bankruptcy and agency costs
This theory fits in the literature initiated by Modigliani and Miller (1958) upon
strong assumptions capital markets are perfect and there are neither tax or
agency costs nor transaction costsand demonstrate that financial structure is
neutral or irrelevant to the value of the company. The proposition put forward by
Miller and Modigliani (1958) was that a companys WACC remains unchanged at
all levels of gearing, implying that no optimal capital structure exists for a
particular company. But that there is an optimum amount of debt for any individual

firm. This amount of debt becomes the firm`s target debt level, that is the firm`s
debt capacity.
They argued that the market value of a company depends on its expected
performance, good investment decision and commercial risk: the market value of a
company and its cost of capital are independent of its capital structure.
Later on, Modigliani and Miller (1963) relax the neutrality axiom and include
taxation: the value of an indebted company is equal to that of a non-corporate debt,
plus the present value of the tax savings from debt and less the present value of
costs related to potential financial difficulties. Hence, because interest are
deductible from taxable profits, firms have an incentive to use debt rather than
equity. The value of a leveraged firm is higher in as much as the tax rebate benefits
only the business itself, save personal income (Miller, 1977).

PECKING ORDER THEORY

Pecking order theory (Donaldson 1961) goes against the idea of companies having
a unique combination of debt and equity finance which minimizes their cost of
capital.
The theory suggests that when a company is looking at financing its long-term
investments, it has a well-defined order of preference with respect to the sources of
finance available to it.
Companies adopt a financial policy, which aims at minimizing the costs associated
with asymmetric information, especially adverse selection, and prefer internal
financing to external financing. This theory assumes that a business leader
complies with the following hierarchy: self-financing, non-risky debt issuance,
risky debt issuance and equity issuance as a last resort. Such behavior eschews a
fall in the prices of shares of the firm; it restricts the distribution of dividends in
order to increase cash flow and reduces the cost of capital by limiting as much as
possible access to loans. Thus, profitable firms enjoy more internal funds available.
COMPARISON OF TRADE OFF THEORY WITH PECKING ORDER
THEORY
There are a number of implications associated with the pecking order theory that
are in differ with the trade-off theory.
1. According to pecking order theory, companies have no target optimum
gearing, because companies chooses its gearing ratio based on financing
needs. Firms have an order of financing, by first using internal funds which
lower the debt ratio, secondly, when firm use debt to finance projects up to

maximum debt capacity, it increases the debt ratio. But later when firm
finance with equity as last resort, it lower the debt ratio again, hence firm
does not pursue target debt ratio to equity.
By contrast, trade off theory is of the view that companies should use debt
ratio at it optimum level when firms set off the benefits of debts, such as the
tax shield, with the cost of debt such as distress cost. That is optimum
gearing occurs at equilibrium when marginal benefits of debt equals the
marginal cost of debt.
2. Trade-Off Theory claims that firms have an incentive to turn to debt as the
generation of annual profits allows benefiting from the debt tax shields. a
positive relationship is expected between the effective tax rate and the cost
of debt.
Contrasting, according to the Pecking Order Theory, firms may be
financially constrained due to the information asymmetry between
managers/owners and investors, and so firms adopt a hierarchy in selecting
sources of finance. In the first place, firms use retained profits; if it is
necessary to turn to external finance, firms use debt with little or no risk,
which usually corresponds to short-term debt; and in the last place, firms
will select external equity. The more profitable is the firm, the greater is its
capacity to accumulate retained profits, and so there is less need to turn to
external finance. A negative relationship is therefore expected between
profitability and debt
3. The trade-off theory view the tradeoff between tax shield and bankruptcy as
the standard model of capital structure, opponent criticize it as far from
reality. They argue that bankruptcy cost appeared to be less than the tax
subsidy.
By contrast, the pecking order theory is more consistent to reality, thus, as
firms finance using more of internal financing, firms will have more equity
ratio than debt ratio.
4. Tradeoff enthusiasts note that large companies with tangible assets are less
exposed to costs of financial distress and would be expected to borrow more.
They interpret the market-to book ratio as a measure of growth opportunities
and argue that growth companies could face high costs of financial distress
and would be expected to borrow less. Pecking-order advocates stress the

importance of profitability, arguing that profitable firms use less debt

because they can rely on internal financing. They interpret the market-tobook ratio as just another measure of profitability.
5. It seems that the pecking order works best for large, mature firms that have
access to public bond markets. These firms rarely issue equity. They prefer
internal financing, but turn to debt markets if needed to finance investment.
Smaller, younger, growth firms are more likely to rely on equity issues when
external financing is required.