Pecking Order Versus Trade Off Theories Essay

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Theories on How Companies Deal With Debt and Financial Distress



Companies can use two popular theories to conceptualize their capital structure. Pecking Order (POT) and Trade-Off (TOT) are always used interchangeably when proving organizations are seeking to ease their way of making capital structure decisions. The following study elucidates the differences between the two theories.



The Pecking Order vs. Trade-Off



The Trade-Off Theory refers to the concept that a company chooses how much equity finance and how much debt finance to use through balancing the benefits and costs (Agarwal, 2013). This theory explains that organizations are often financed partly with equity and partly with debt. Pecking Order Theory argues that the cost of financing increases with asymmetric data. There are three sources of financing for a company: internal funds, new and debt equity. Firms prioritize their financing sources. First, they prefer preferring internal financing, and then debt, lastly equity is used as the last resort. This implies they use internal financing first when this is depleted; they use debt, and when it is no more sensible to solicit debt, they turn to equity (Puntaier, 2010).



The TOT addresses the limitations seen as inconsistent with the advantage behavior provided some level of information (Agarwal, 2013). This theory postulates that organizations would naturally finance new investments using debts as against equity; first to trade-off tax liabilities and then second to cause some level of scarcity on the stock as a means of increasing a company's worth.

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However, opponents of the TOT claim that it failed to explain the cause of a decline in stock prices as seen when companies announce new issues. The ensuing discussion evidence that debt financing correlated to periods in positive direction especially about economic boom and rates. Conversely, the POT disagrees on the degree of simplicity postulated by the TOT. POT explains that the availability of unequal data and the projected cost of bankruptcy or distress will adversely affect managers' choice of financing (Parrino, 2011). The concluding consideration of the POT is that companies are most likely to issue equity following a share price increase. This is explained by the fact that if there were a fixed target leverage ratio, companies would prefer to issue debts.



Specific Businesses Following the Trade-Off Theory and the Pecking-Order Theory



Coca-Cola uses debt when financing its operations. The company maintains debt levels, which they consider prudent depending on interest coverage ratio, cash flows and percentage of debt to capital (Parrino, 2011). This approach benefits the company because it allows them to lower their overall cost of capital thus increasing their return on shareholder's equity. Coke's debt management strategies, in combination with their share purchase policies and an investment activity results in current liabilities surpassing current assets. Payments….....

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References


Agarwal, Y. (2013). Capital Structure Decisions: Evaluating Risk and Uncertainty. New York: Wiley.

Baker, H. K., & Martin, G. S. (2011). Capital Structure And Corporate Financing Decisions: Theory, Evidence, and Practice. Hoboken, N.J: Wiley.

Parrino, R. (2011). Fundamentals of Corporate Finance. Hoboken, N.J: Wiley.

Puntaier, E. (2010). Capital Structure and Profitability: S&P 500 Enterprises in Light of the 2008 Financial Crisis. Hamburg: Diplomica-Verl.

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