Corporate Finance: Essay Quiz Capital Structure 06

A firm has zero debt in its capital structure. Its overall cost of capital is 9%. The firm is considering a new capital structure with 40% debt. The interest rate on the debt would be 4%. Assuming that the corporate tax rate is 34%, what would be its cost of equity capital with the new capital structure?

Answer:

To determine the cost of equity capital for a firm considering a new capital structure with 40% debt, we can use the Modigliani-Miller Proposition II, which states that the cost of equity increases linearly with leverage due to the increased financial risk to equity holders.

Given Data

• Current overall cost of capital (WACC): 9%
• Debt proportion (D/V): 40% or 0.40
• Equity proportion (E/V): 60% or 0.60 (since the firm has zero debt initially)
• Cost of debt (Kd): 4% or 0.04
• Corporate tax rate (T): 34% or 0.34

Step 1: Calculate After-Tax Cost of Debt

The after-tax cost of debt is calculated as follows:

$${\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">K</span></span>}}_{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">d</span></span>}}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">(</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">1</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">-</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">T</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">)</span></span><span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span>{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">K</span></span>}}_{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">d</span></span>}}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\times </span></span><span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">(</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">1</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">-</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">T</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">)</span></span><span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.04</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\times </span></span><span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">(</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">1</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">-</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.34</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">)</span></span><span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.04</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\times </span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.66</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.0264</span></span>}\text{<span style="font-family: verdana;"><span style="font-size: small;"> or </span></span>}\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">2.64</span></span>}\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\%</span></span>}$$

Step 2: Set Up the WACC Equation

The WACC can be expressed as:

$$\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">W</span></span>}\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">A</span></span>}\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">C</span></span>}\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">C</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">E</span></span>}\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">/</span></span>}\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">V</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\cdot </span></span>{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">K</span></span>}}_{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">e</span></span>}}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">+</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">D</span></span>}\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">/</span></span>}\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">V</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\cdot </span></span>{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">K</span></span>}}_{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">d</span></span>}}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">(</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">1</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">-</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">T</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">)</span></span>$$

Substituting the known values:

$$\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.09</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.60</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\cdot </span></span>{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">K</span></span>}}_{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">e</span></span>}}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">+</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.40</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\cdot </span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.0264</span></span>}$$

Step 3: Solve for Cost of Equity (K_e)

First, calculate the contribution of debt to WACC:

$$\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.40</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\cdot </span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.0264</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.01056</span></span>}$$

Now substitute this back into the WACC equation:

$$\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.09</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.60</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\cdot </span></span>{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">K</span></span>}}_{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">e</span></span>}}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">+</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.01056</span></span>}$$

Rearranging to isolate $K_e$:

$$\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.60</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\cdot </span></span>{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">K</span></span>}}_{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">e</span></span>}}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.09</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">-</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.01056</span></span>}$$

$$\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.60</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\cdot </span></span>{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">K</span></span>}}_{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">e</span></span>}}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.07944</span></span>}$$

$${\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">K</span></span>}}_{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">e</span></span>}}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span>\frac{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.07944</span></span>}}{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.60</span></span>}}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\approx </span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.1324</span></span>}\text{<span style="font-family: verdana;"><span style="font-size: small;"> or </span></span>}\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">13.24</span></span>}\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\%</span></span>}$$

On 18^th May, you purchased RM1000 shares of BuyLo Stock. On 5^thJune, you sold 200 shares of this stock for RM21 a share. You sold an additional 400 shares on 8^th July at a price of RM22.50 a share. The company declared a RM 0.50 per share dividend on 25^th June to holders on record as of Thursday, 10^th July. This dividend is payable on 31^st July. How much dividend income will you receive on 31^st July as a result of your ownership of BuyLo Stock?  

Answer:

To determine the dividend income you will receive on July 31 as a result of your ownership of BuyLo Stock, we need to follow these steps:

1. Identify the number of shares you own as of the record date for the dividend.
2. Calculate the total dividend income based on the declared dividend per share.

Step 1: Determine Shares Owned on Record Date

You purchased RM1,000 worth of BuyLo Stock, but we need to know how many shares that represents. However, since the price per share is not given, we cannot calculate the exact number of shares you initially owned.Let's assume you purchased shares at an unknown price $P$. The number of shares purchased would be:

$$\text{<span style="font-family: verdana;"><span style="font-size: small;">Total Shares Purchased</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span>\frac{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">1000</span></span>}}{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">P</span></span>}}$$

Step 2: Calculate Shares Held on Record Date

You sold:

• 200 shares on June 5.
• 400 shares on July 8.

Assuming you initially had $N$ shares, after selling 200 shares, you have:

$$\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">N</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">-</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">200</span></span>}$$

After selling another 400 shares, you have:

$$<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">(</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">N</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">-</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">200</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">)</span></span><span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">-</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">400</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">N</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">-</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">600</span></span>}$$

Step 3: Determine Dividend Eligibility

The company declared a dividend of RM0.50 per share on June 25, payable to holders of record as of July 10. Since you sold your last shares on July 8, you will still be eligible to receive dividends for all the shares you held before that date.

Step 4: Calculate Total Dividend Income

The total number of shares you hold before selling is $N-600$. Therefore, your total dividend income will be:

$$\text{<span style="font-family: verdana;"><span style="font-size: small;">Dividend Income</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span><span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">(</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">N</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">-</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">600</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">)</span></span><span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\times </span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.50</span></span>}$$

To finalize the calculation, we need the initial price per share $P$ to determine $N$. However, assuming you had enough shares such that $N-600$ is a positive number (i.e., you had more than 600 shares initially), your total dividend income on July 31 would be:

$$\text{<span style="font-family: verdana;"><span style="font-size: small;">Dividend Income</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span><span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">(</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">N</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">-</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">600</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">)</span></span><span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\times </span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">R</span></span>}\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">M</span></span>}\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.50</span></span>}$$

If for instance, you had originally bought 1000 shares (assuming each share was RM1), then:

• You would have sold 200 + 400 = 600 shares,
• Remaining: 1000 - 600 = 400 shares.

Thus your dividend income would be:

$$\text{<span style="font-family: verdana;"><span style="font-size: small;">Dividend Income</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">400</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\times </span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">R</span></span>}\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">M</span></span>}\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">0.50</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">R</span></span>}\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">M</span></span>}\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">200</span></span>}$$

Therefore, if you started with enough shares to ensure $N-600>0$, your dividend income would be calculated based on how many shares you held before selling. If more information about the initial purchase price per share is available, we could provide a precise amount for your dividend income.

Rovia industries has 15,000 shares of stock outstanding with a par value of RM1 per share and a market price of RM36 per share. The balance sheet shows RM15,000 in the common stock account, RM315,000 in the capital – in – excess of par account, and RM189,000 in the retained earning account. The firm just announced a 3 – for – 2 stock split. How many shares of stock will be outstanding after the split?

Answer:

To determine how many shares of stock will be outstanding after the 3-for-2 stock split for Rovia Industries, we can follow these steps:

Step 1: Current Number of Shares Outstanding

Rovia Industries currently has 15,000 shares of stock outstanding.

Step 2: Understanding the Stock Split Ratio

A 3-for-2 stock split means that for every 2 shares an investor owns, they will receive 3 shares. This effectively increases the number of shares outstanding.

Step 3: Calculate the New Number of Shares

To calculate the new number of shares after the split, we can use the following formula:

$$\text{<span style="font-family: verdana;"><span style="font-size: small;">New Shares</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span>\text{<span style="font-family: verdana;"><span style="font-size: small;">Current Shares</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\times </span></span><span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">(</span></span>\frac{\text{<span style="font-family: verdana;"><span style="font-size: small;">New Ratio</span></span>}}{\text{<span style="font-family: verdana;"><span style="font-size: small;">Old Ratio</span></span>}}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">)</span></span>$$

In this case:

• Current Shares = 15,000
• New Ratio = 3 (the number of new shares received)
• Old Ratio = 2 (the number of old shares held)

Substituting these values into the formula gives:

$$\text{<span style="font-family: verdana;"><span style="font-size: small;">New Shares</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">15</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">,</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">000</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\times </span></span><span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">(</span></span>\frac{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">3</span></span>}}{\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">2</span></span>}}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">)</span></span>$$

Calculating this:

$$\text{<span style="font-family: verdana;"><span style="font-size: small;">New Shares</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">15</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">,</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">000</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">\times </span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">1.5</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">=</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">22</span></span>}<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">,</span></span>\mathrm{<span\; style="font-family:\; verdana;"><span\; style="font-size:\; small;">500</span></span>}$$

Explain the trade of and pecking order theory as it relate to capital structure decisions.

Answer:

The trade-off theory and pecking order theory are two influential frameworks that explain how firms make capital structure decisions. Each theory presents a different perspective on the optimal mix of debt and equity financing.

Trade-Off Theory

The trade-off theory posits that firms strive to balance the benefits and costs associated with debt and equity financing to determine their optimal capital structure. Here are the key components:

1. Benefits of Debt:
   • Tax Shield: Interest payments on debt are tax-deductible, which reduces the overall tax burden for the firm. This tax advantage incentivizes firms to use more debt in their capital structure.
   • Lower Cost of Capital: Because debt is generally cheaper than equity (due to lower required returns), increasing leverage can lower the firm's weighted average cost of capital (WACC) up to a certain point.
2. Costs of Debt:
   • Financial Distress: As a firm increases its debt levels, it faces higher risks of financial distress and bankruptcy. These risks can lead to direct costs (e.g., legal fees) and indirect costs (e.g., loss of customers, reduced employee morale).
   • Agency Costs: High levels of debt may create conflicts between equity holders and debt holders, leading to agency problems that can further increase costs.
3. Optimal Capital Structure:
   • The trade-off theory suggests that there is an optimal level of debt where the marginal benefit of the tax shield equals the marginal cost of financial distress. Firms will adjust their capital structure until they reach this optimal point, maximizing their overall value.

Pecking Order Theory

In contrast, the pecking order theory, proposed by Myers in 1984, emphasizes a hierarchy in financing choices rather than an optimal capital structure:

1. Financing Hierarchy:
   • Firms prefer internal financing (retained earnings) over external financing because it avoids transaction costs and potential dilution of ownership.
   • If internal funds are insufficient, firms will opt for debt financing next.
   • Equity financing is considered a last resort due to the higher costs associated with issuing new equity (e.g., underpricing, dilution).
2. Information Asymmetry:
   • The pecking order theory highlights that managers have more information about the firm's prospects than external investors. Consequently, issuing new equity may signal that the firm is overvalued, leading to adverse selection problems.
   • This information asymmetry drives firms to follow a specific order in financing decisions: first using retained earnings, then debt, and finally issuing new equity.
3. No Optimal Capital Structure:
   • Unlike the trade-off theory, the pecking order theory does not suggest an optimal capital structure. Instead, it reflects how firms behave based on their internal conditions and market perceptions.

Comparison and Implications

• Trade-Off Theory: Focuses on balancing benefits (tax shields) against costs (financial distress) to find an optimal capital structure.
• Pecking Order Theory: Emphasizes a preference for internal financing and establishes a hierarchy for financing decisions without suggesting an optimal structure.

Both theories provide valuable insights into capital structure decisions. The trade-off theory is useful for understanding why firms might target specific leverage ratios based on tax benefits and distress costs. In contrast, the pecking order theory explains how firms prioritize their financing choices based on internal resources and external perceptions. Firms often exhibit behaviors consistent with both theories depending on their circumstances, market conditions, and strategic objectives.