Market-To-Sheet Theory Vs Pecking Order Theory

equity instead of riskless debt. To avoid this discount, managers avoid equity whenever possible. The Myers and Majluf model predicts that managers will follow a pecking order, using up internal funds first, then using up risky debt, and finally resorting to equity. In the absence of investment opportunities, firms retain profits and build up financial slack to avoid having to raise external finance in the future. The pecking order theory regards the market-to-book ratio as a measure of investment opportunities. With this interpretation in mind, both Myers (1984) and Fama and French (2000) note that a contemporaneous relationship between the market-to-book ratio and capital structure is difficult to reconcile with the static pecking order model. Iteration of the static version also suggests that periods of high investment opportunities will tend to push leverage higher

It assumes that there are benefits to leverage with capital structure used until an optimal capital structure is attained. The theory recognized that debt interest is tax deductible. This reduces tax liability thus increasing tax shield. A high proportion of debt in a company makes it very risky for investors to invest in it hence they demand a high premium on stock or high dividend. The theory assumes that a firm has an optimum capital structure based on trade off between costs and benefits of using debt. This theory does not explain the conservative

Firm’s optimal debt ratio is determined by a tradeoff between the bankruptcy cost and tax advantage of borrowing and it is achieved at the point when the marginal present value of the tax on additional debt is equal to the increase in the present value of financial distress cost (Owalobi & Inyang,