Trade Off and Pecking Order Theory
Compare and contrast trade-off theory and pecking-order theory.
Describe a specific business that seems to follow trade-off theory and another that
follows pecking-order theory.
Why would these theories be more applicable in some industries than others?
Compare and contrast trade-off theory and pecking-order theory
The Trade-off Theory or Static Trade-off Theory states that a firm’s capital structure
decision involves a trade-off between the tax benefits of debt and the costs of financial stress.
Firms choose their capital structures by trading off the benefits of debt financing such as tax
shields, against the costs associated with financial distress and bankruptcy. The implication
shows how each individual firm has an optimal amount of debt, which becomes the firm’s target
debt level (Ross, Westerfield, & Jaffe, 2013). The company will choose how much debt to
finance and how much equity to finance by balancing the costs and benefits of each. This theory
shows how corporations are financed with debt and equity.
The Pecking Order Theory is a hierarchy or financing strategy in which using internally
generated cash is at the top, issuing new equity is at the bottom, and issuing new debt is in the
middle (Ross et al, 2013). Firms would prefer internal financing, and debt is preferred over
equity if the firm has to result to external financing. When firm’s issue equity it means they have
to bring external ownership into the company. These two theories are similar because they
weight the benefits and costs between debt and equity using the debt ratio. The two theories are
different because in the Trade-off Theory asset tangibility, profitability and tax shield are
significant. In the Pecking Order Theory the most influential factors are long term profitability
and investment opportunities (Vatavu, 2012).
Describe a specific business that seems to follow trade-off theory and another that
follows pecking-order theory.
A business that follows the Trade-off Theory is one that is well established
with enough equity generated in the firm. Microsoft is a business that could follow the trade off
theory because it was not at its optimal capital structure and was not maximizing its value as an
all equity firm. A business that follows the Pecking-order Theory is a smaller business. These
businesses use their internal resources first before turning to lenders or investors to keep the
business operational.
Why would these theories be more applicable in some industries than others?
These theories could be more applicable to some firms than others because the level of
debt and equity in a firm plays a major significance. These theories apply to firm specific factors
that show most significance in the capital structure of asset tangibility, size, investment
opportunities, profitability, and tax shield (Vatavu, 2012).
References
Ross, S. A., Westerfield, R. W., & Jaffe, J. (2013). Corporate finance (10 th ed.). New
York:
McGraw-Hill Irwin.
Vatavu, S. (2012). Trade-off versus Pecking Order Theory in listed companies around the
world.
Annals of the University of Petrosani Economics, 12(2), 285-292. Retrieved from
http://www.upet.ro.
Write a one paragraph hear to expand and constructively challenge the above postings,
using a scholarly article to support your point.
Post 2
Capital Structure Theory
Capital structure determination poses a challenge to financial executives. Corporate
leaders consider assets, profitability, size and debt when selecting a capital structure model. The
purpose of this discussion is to compare and contrast trade-off and pecking-order capital
structure theories.
Trade-off vs. Pecking-Order Theory
Trade-off and pecking-order theory are two capital structure options used by businesses.
Financial leaders must determine the best methodology for funding capital projects, expansions,
or meeting shareholder obligations. Trade-off theory states that a company balances the benefits
of debt to increase capital with the risk of the cost of bankruptcy (Ross, Westerfield, & Jaffe,
2013; Vatavu, 2012). Conversely, pecking-order theory dictates a hierarchy decision process for
raising capital where internal funding is the priority then debt financing (Guo & Leinberger,
2012; Ross et al., 2013). In a firm where leveraging debt provides a maximum tax benefit, the
financial officer may choose a trade-off capital structure model whereas in a company with low-
risk tolerance pecking order may be the most beneficial option.
Capital Structure Theory Application
Trade-off theory focuses on debt leverage for the purpose of raising capital. Large or
established firms are most likely to employ the trade-off theory in their capital structure (Lopez-
Gracia & Sogorb-Mira, 2008; Vatavu, 2012). Big companies have many assets along with stable
revenue that allows for debt leverage tolerance. Businesses that are widely diversified such as
Disney, also represent an example of a firm that employees trade-off theory in that the can take
advantage of tax benefits because they have little risk of bankruptcy (Vatavu, 2012). Lopez-
Gracia and Sogorb-Mira (2008) reviewed more than 3,500 small and moderate sized company’s
capital structure and found that the consumer and manufacturing industries are most likely to
employ the trade-off capital structure theory.
Pecking-order capital structure favors internal financing over external funding but like trade-off
theory is not applicable to all companies. Small firms and new business are most likely to
employ pecking-order theory because the tax shield benefits do not outweigh the cost and risk of
debt leverage (Lopez-Gracia & Sogorb-Mira, 2008). Smaller firms who favor internal financing
of projects and tech industry where the company has intangible assets utilize the pecking-order
theory (Guo & Leinberger, 2012). Companies who cannot leverage debt or want to appear
stronger may implement the pecking-order capital structure theory.
Rationale for Trade-off and Pecking-order Theories
The rationale for choosing one theory over another depends on the company type, size,
and goals. Trade-off capital structure provides improved stability to balance debt and equity
while funding capital budgets (Vatavu, 2012). Conversely, firms who are vulnerable, intolerant
to risk, faced with high financing costs, or are in a growth phase benefit from pecking-order
capital structure (Guo & Leinberger, 2012; Lopez-Gracia & Sogorb-Mira, 2008; Vatavu, 2012).
The benefits of tax deductions may not be an advantage to the small or emerging company
attempting to establish itself. Therefore, pecking-order is the optimal choice in the capital
structure.
Conclusion
A capital structure theory selection must be pondered carefully. Business and financial leaders
must choose a structure that fits the company’s size, operations, financial needs, and risk
tolerance. Trade-off theory is best applied to businesses that are established, profitable and have
tangible assets where debt leverage maximizes tax benefits to funding. Pecking-order theory, on
the other hand, supports the smaller or emerging firm who prefer to finance through their internal
equity and earnings. The goal of the capital structure is to provide funding for capital budgets
therefore selecting a practice theory will enable a company to establish appropriate funding
while remaining profitable.
References
Guo, E., & Leinberger, G. (2012). Firm growth and financial choices in Pennsylvania firms: An
empirical study about the pecking order theory. Journal of Accounting and Finance, 12, 123-
financing SMEs. Small Business Economics, 31, 117-136.
Ross, S. R., Westerfield, R. W., & Jaffe, J. (2013). Corporate finance (10 th ed.). NY:McGraw-
Hill.
Vatavu, S. (2012). Trade-off versus pecking order theory in listed companies around the world.
Annals of the University of Petrosani, Economics, 12, 285-292.
Write a one paragraph hear to expand and constructively challenge the above postings,
using a scholarly article to support your point.
