Trade Off, Signaling, Agency Cost and Pecking Order Theories

Explain the tradeoff, signaling, agency cost and pecking order theories of capital budgeting.

·  Trade – off is a firm’s capital structure decisions involve a trade – off between the tax benefit of debt and the costs of financial distress. The implication is that there is an optimal amount of debt for any individual firm. This amount of debt becomes the firm’s target debt level. Because financial distress costs cannot be expressed in a precise way, no formula has yet been developed to determine a firm’s optimal debt level.

· Signaling – financing decision by managers that provide signaling effect to investors that suggest increase the value of firm. For example; debt signaling, concerning exchange offers. Firms often change their debt levels through exchange offers, of which there are two types. The first type of offer allows stockholders to exchange some of their stock for debt, thereby increasing leverage. The second type allows bondholders to exchange some of their debt for stock, decreasing leverage. The market infers from an increase in debt that the firm is better off, leading to a stock price rise. Conversely, the market infers the reverse from a decrease in debt, implying a stock price fall. Thus, we say that managers signal information when they change leverage. 

· Agency cost – when a firm has debt, conflicts of interest arise between stockholders and bondholders. Because of this, stockholders are tempted to pursue selfish strategies. These conflict of interest, which are magnified when financial distress is incurred, imposed agency costs on the firm. 

·  Pecking order theories – the pecking order theories of capital structure is the most influential theories of corporate leverage. It explains the inverse relationship between profitability and debt ration. Rule of pecking order:

-          Use internal financing

-          Issue the safest securities first.

Reference:

Corporate Finance Book, Stephen A.Ross, Randolph W.Westerfield and Jeffrey Jaffe, Ninth Edition.