Pecking & Trade Off Theory

2) The higher ratio of Debt to Total Equity may result to the lower of the debt credit rating. The lower of the credit rating will result to increase of the interest rate which will cost more to the company.

The decision to choose the issuance of preferred shares or unsecured notes is balanced not only by the cost of the capital to the bank, but also the characteristics of the instruments themselves. Issuing preferred stock may be advantageous to the current firm's management due to its unique characteristics over ordinary stock, as well as its hybrid status as a financing instrument.

Before investors invest in a company, he or she must take various items into consideration. First, both paid in capital and earned capital are looked at. These items tell investors how well the company is doing and if the company is profitable. Next, investors look at earnings, basic and diluted. Once an investor takes the above into consideration, he or she can then make the decision whether to invest in a company or not. This paper will discuss why it is important to keep paid in capital separate from earned capital. How earned capital and basic earnings are more important than paid in capital and diluted earnings will also be discussed.

Issuing new shares and moving to retire outstanding debt reduces leverage reduces the degree of exposure and magnification that the company will experience due to cash flow and other economic fluctuations-by reducing fixed costs and spreading the exposure around to a wider pool of investors (Bierman, 2003). This would be most advantageous during a year when it is expected that there will be a tightening of

Landry’s Debt to Asset ratio also increased from year 2002 to 2003. In 2002 Landry had a debt to asset ratio of 0.39. In 2003 Landry’s debt to asset ratio increased to 0.45. While both numbers are acceptable and considerably low, the increase from 2002 to 2003 could influence potential investors to not invest in Landry’s stock. This increase also suggests that Landry’s debt also increased from 2002 to 2003. Overall, while there was a slight increase from 2002 to 2003 Landry’s still had a good debt to asset ratio. We think that a contributing factor to the debt

Does the capital structure of a firm really matter? If so, how and why does it matter? Practitioners and scholars of corporate finance have debated these questions for several years and have found it difficult to come up with definitive answers. The classical work of Modigliani and Miller (1958) provided the impetus for what is now, orthodox corporate finance theory on the optimal capital structure of firms. They postulated that, in a perfect or frictionless capital market, the choice between debt and equity financing has no material effect on the value of the firm. Stern and Chew (2003) noted that following the Modigliani-Miller propositions, academic researchers in the 1960s and 1970s turned their attention to market imperfections

Miller and Modigliani’s second proposition focuses on the risks associated when a firm takes on more debt. “The expected yield of a share of stock is equal to the appropriate capitalization rate pk for a pure equity steam in the class, plus a

If the firms funding requirements are larger than their retained earnings, they must issue debt as this is preferred to issuing equity. Based on this theory, a firm’s financing policies could be viewed as signalling management’s view of the firm’s stock value (Wang & Lin 2010).Myers and Majluf (1984) also add that if firms issued no new securities but only used its retained earning to support the investment opportunities, the information asymmetric could be resolved. This suggests that issuing equity turn out to be more expensive as asymmetric information insiders and outsiders increase. Large firms should then issue debt to avoid selling under priced securities. As the requirement for external financing increases, businesses will work down the pecking order, from safe to riskier debt, perhaps to convertible securities or preferred stock, and finally to equity as a last resort. Each firm's debt ratio therefore reflects its cumulative requirement for external financing (Myers 2001).The pecking order theory clarifies why the bulk of external financing comes from debt. It also describes why organizations that are more profitable borrow less: since their goal debt ratio is, low-in the pecking order they do not have a goal since profitable firms have more internal financing available.

The static trading theory and pecking order theory are two financial principles that help companies choose their capital structure. Both play the same role in the decision-making process depending on the type of capital structure the company wishes to achieve. However, empirically the pecking order theory is most widely used in determining the company's capital structure.

Asymmetric information refers as when the managers have more information than the investors. However, if the managers have the information that favor the management and acts in the interest of existing shareholders, the management will not issue new shares and give up the good investment. The term issuing new shares will send signals to the investors. The investors may think that the share price of the firm is overvalued since the firm must get funding from the new investors. Thus, in order to prevent all these misleading information, pecking order theory suggests to use internal funds as the first source of funding and follow by debt and equity financing (Myers and Majluf, 1984; Myers,

|result company equity value, which allows for more borrowing of money |Tight money markets makes borrowing more difficult, especially with |

This section starts with the theory of irrelevancy of capital structure. Following subsections give the overview of theories that suggest that the capital

Q1. Whether a country’s capital market is debt –oriented or equity oriented has a significant impact on the financial reporting that develops in the country, both at the cosmetic and at the substantive level. Choose a equity oriented country and a debt oriented country, and obtain two corporate annual reports from each. Comment on the similarities and the differences of the reports

Debt financing is typically easier to get than equity financing. If the company is showing good results and has positive cash flow, debt can typically be raised by going to banks. Though lending is still tighter than in years past, it has loosened significantly in the last two years allowing for business growth financing.

The pecking order model assumes that the distribution of informational asymmetry is homogeneous across different industries. To examine the adequacy of the two assumptions under each theory, first we classify firms into industries, using Fama and French industry classification; this enables us to control for the nonhomogeneity of the firms’ characteristics across industries and the temporal distribution of informational asymmetry among industries; second, we use a spline regression model to test for the symmetric behavior assumption. The results show that the symmetrical rate of adjustment assumption under the trade-off model is rejected across all industries; firms tend to adjust faster toward the target leverage when they are above the target relative to when they are below the target leverage. We find no evidence to support the homogeneous coefficient across industries as the adjustment rate varies significantly across industries. For the pecking order model, we reject the symmetric behavior assumption at the industry level as well as across all industries. Firms have the tendency to reduce debt by a significantly higher proportion when they have financing surplus comparing to the proportion of debt issued when they have financing deficit.