In tradeoff theory, the search is for an optimum capital structure. The tradeoff is between the interest tax shield, bankruptcy costs and agency costs. The firm would seek the optimum debt ratio that maximises the value of the firm. It therefore balances the marginal present values of interest tax shields against bankruptcy costs and agency costs. The theory therefore predicts the mean reversion of the actual debt ratio towards a target or optimum and also predicts a cross-sectional relation between average debt-ratios and asset risk, profitability, tax status and asset type.
In pecking order theory, there is no optimal debt ratio. Due to asymmetric information and signaling problems associated with issuing equity, financing policies follow a hierarchy, with preference for internal over external financing and for debt over equity. The debt ratio is therefore a cumulative result of hierarchical financing over time.
2. Managers are prohibited from trading in the shares of the firm. This prevents them from going against the interests of the firm, example short-selling the shares before announcing bad news about the firm even though the firm is doing well.
3. 3. Investors use the face value of debt held by the company to tell whether the firm is successful (type A) or unsuccessful (type B).
4. By changing the capital structure, the firm alters the perceived market value of the firm even if the true value of the firm remains the same.
1 period interest rate r
t = 0 t=1
Market perception Truth is revealed
Manager's compensation, M, paid out at the end of the period t=1:
V1 if V1 D
M = (1 + r)0V0 + 1
V1 - C if V1 < D
0, 1: positive weights of the value of the firm
r: one period interest rate
V0, V1: value of the firm at t=0 and t=1
VA: value of successful type firm at t = 1