Analysis of Trade-Off and Pecking Order Theory on Company's Capital Structure
Introduction
In many recent studies, it has a growing concern whether pecking order or trade-off theory can give better determination on firms’ “optimal” capital structure in different scenarios. In trade-off theory, it helps to determine the debt proportion and maintain optimal balance in order to maximise company’s market value. However, pecking order theory promotes that companies tend to issue debts when company has internal financial deficit or deviation from target capital leverage. Hence, it shows mixed evidences such as Shyman-Sunder and Myers (1999) found more supportive evidences for pecking order theory but Hovakimian, Opler and Titman (2001) examines that firms’ debt-equity issuance choice is significant for repurchase decision of debts compared to securities issues during target leverage deviation. Therefore, should company follow pecking order model in short-run and reversion of target leverage in long-run?
Capital Structure
According to “classic” proposition of Modigliani and Miller (1958), they claim that firm’s value is independent of capital structure but market value affects firm’s debt and equity level and assume under perfect capital market condition, managers can ignore shareholders wealth and many considerations about capital structure decision since companies are financed irrelevant to its market value. However, it is criticised that imperfect market do actually exist, different source of external finance will affect managers’ investment decision and company’s value will affect capital structure, i.e. bankruptcy cost, agency cost, tax can affect firm’s optimal capital structure and market value maximisation (Warner 1977, Jensen and Meckling 1976).
Static Trade-off theory (Target Capital Theory)
According to (Baxter, 1967) trade-off models, firms will maintain optimal capital structure by balancing the cost and benefit of debt, i.e. tax shield and financial distress cost. Modigliani and Miller (1963) also extended their previous study
In many recent studies, it has a growing concern whether pecking order or trade-off theory can give better determination on firms’ “optimal” capital structure in different scenarios. In trade-off theory, it helps to determine the debt proportion and maintain optimal balance in order to maximise company’s market value. However, pecking order theory promotes that companies tend to issue debts when company has internal financial deficit or deviation from target capital leverage. Hence, it shows mixed evidences such as Shyman-Sunder and Myers (1999) found more supportive evidences for pecking order theory but Hovakimian, Opler and Titman (2001) examines that firms’ debt-equity issuance choice is significant for repurchase decision of debts compared to securities issues during target leverage deviation. Therefore, should company follow pecking order model in short-run and reversion of target leverage in long-run?
Capital Structure
According to “classic” proposition of Modigliani and Miller (1958), they claim that firm’s value is independent of capital structure but market value affects firm’s debt and equity level and assume under perfect capital market condition, managers can ignore shareholders wealth and many considerations about capital structure decision since companies are financed irrelevant to its market value. However, it is criticised that imperfect market do actually exist, different source of external finance will affect managers’ investment decision and company’s value will affect capital structure, i.e. bankruptcy cost, agency cost, tax can affect firm’s optimal capital structure and market value maximisation (Warner 1977, Jensen and Meckling 1976).
Static Trade-off theory (Target Capital Theory)
According to (Baxter, 1967) trade-off models, firms will maintain optimal capital structure by balancing the cost and benefit of debt, i.e. tax shield and financial distress cost. Modigliani and Miller (1963) also extended their previous study