Capital Determinants

Running Head: Determinants of Capital Structure: A Comparison of Trade off Theory and Pecking Order Theory

Determinants of Capital Structure: A Comparison of Trade-off Theory and Pecking Order Theory

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In an attempt to explain how firms choose the make-up of their capital structure, and the factors that influence the firms’ choice, many theories have emerged. Despite the extensive research and emergence of theories dedicated to capital structure, Myers (2001) insists that there is no universally applicable theory. There are many and complex factors that are unique to varying situation that will affects a firm’s decision.

The pecking order theory according to Myers and Majluf, (1984) suggests that firms tend to favour the use of retained earnings compared to external financing. In the event the firm requires external financing then debts are more preferable as compared to equity. This scenario can be attributed to two possibilities, the tax code and asymmetric information. The deferential tax code may be in such a way that money paid into the firm is not taxed while that being paid out is taxed. An alternative view of the peck order theory advanced by, Halov and Heider (2005) when asymmetric information is predominantly on risks rather than value firms would prefer equity. With increased volatility of asset value us of equity is preferred to debt to fill the gap. This version of pecking order theory can be used to explain the capital structure of mature firms whose asymmetric information is more on value. Brealey and Myers, (2001) further observes the appropriateness of this version of pecking order theory in explaining young, small and high growth firms financial behaviour with high asymmetric information on risks. The theory is more about balancing the internal and outside financing rather than pursuing an optimal leverage ratio. To further understand the pecking theory let’s look closely at its most crucial...