Difference Between Pecking Theory And Tradeoff Theory

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2. THEORETICAL FRAMEWORK Two traditional capital structure theories guide most academic literature concerning financing decisions; the pecking order theory and the (static) tradeoff theory. This section will elaborate on the implications of these theories in order to clarify that the market timing theory cannot be explained by one of these theories. The existing academic literature concerning market timing will also be discussed in this section. Tradeoff theory In a perfect market without taxes, costs of financial distress, agency costs and any other imperfections, the capital structure of a firm is irrelevant in terms of costs. The tradeoff theory adds some imperfections to this perfect market, by which it does create a preference for external financing. The costs of equity and debt now differ and an optimal target ratio can be…show more content…
The focus of this theory is the strict order in which financing is favored. External financing is never preferred above internal financing. The pecking order theory states that external financing is too expensive, because outside investors possess less information than insiders and therefore involve more costs than necessary. Practically speaking this could imply that equity investors pay too little for a share, and that debt investors have interest rates set too high. Retained earnings are the preferred method of financing according to the pecking order theory. When this source is used up or no longer available and the firm is compelled to use external financing, debt is preferred over equity. Debt is preferred over equity because the agency costs involved with the issuance of debt are lower. An issue of debt signals confidence and it signals that the shares are overvalued. On the other hand, an issue of equity signals that the share is currently undervalued. This phenomenon is referred to as adverse selection (Frank & Goyal,
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