Theories of Financing choices

Two theories are commonly advanced to explain real world corporate financing behaviour, that is trade off theory and the pecking order theory.

Trade off theory

While using debt-equity ratio, financial managers of a look at the tradeoff between the tax provided by the cost of financial distress. Following figure shows the nature of the trade-off.

According to the trade off theory, profitable firms with stable, tangible assets would have higher debt-equity ratios. On the other hand, unprofitable forms with risky, intangible assets tend to have lower debt equity ratio. 

How well does the trade of theory explain corporate financing behaviour ? It explains reasonably well some industry differences in capital structures. For example, power companies and refineries use more that and their assets are tangible and safe. High- tech growth companies, on the other hand, dirilis because the assets are mostly intangible and somewhat risky.

The trade off theory, however, cannot explain why some profitable company depend so little on debt. For example, Hindustan lever limited and Colgate Palmolive India limited, two highly profitable companies, use very little debt. They pay large amounts by way of income tax which they can possibly saved by using death without causing any concern about their solvency.

Pecking order theory

There is an alternative theory which explains why a profitable firms used little debt:-

a) internal Finance (retained earnings)

b) debt Finance

c) external equity Finance

A file first taps retained earnings. Its timely attraction is that comes out of profits and not much effort is required to get it. Further, the capital market ordinary does not view the use of retained earnings negatively. 

When the financing needs of the firm exceed its retained earnings. It seeks debt finance. There is very little scope for debt to be mispriced, a debt issue does not ordinarily cause concern to investors. Also, A debt issue prevents dilution of control.

External equity appears to be the last choice. A great deal of effort may be required in obtaining external equity. More important, while retained earnings is not regarded by the capital market as a negative signal, external equity is often perceived as 'bad news'. Investors generally believed that a firm issues externally equity when it considers it stock over price in relation to its future prospects. 

Thus, according to the pecking order theory, there is no well defined target debt equity ratio, is there too kind of equity, internal and external. While the internal equity (retained earnings) if at the top of the pecking order, the external equity is at the bottom. The pecking order theory explains why highly profitable forms generally use little debt. The borrow less as they don't need much external finance and not because they have a low target debt- equity ratio. On the other hand, less profitable firms borrow more because their financing needs exceed retained earnings and debt finance comes before external equity in the pecking order.

Reference:  Fundamentals of Financial Management by Prasanna Chandra.