The document discusses theories of capital structure and financial distress. It explains that the trade-off theory views capital structure as a balance between the tax benefits of debt and costs of financial distress. The pecking order theory states that firms prefer internal financing, then debt, and equity as a last resort, to avoid sending negative signals to investors. The pecking order theory is based on the idea that managers have more information than investors, so equity issuance could be seen as bad news.

1. Financial Distress
Maximum value of firm
Costs of
Market Value of The Firm
financial distress
PV of interest
tax shields
Value of levered firm
Value of
unlevered
firm
Optimal amount
of debt
Debt/Total Assets

2. Capital Structure and Financial Distress
Costs of Financial Distress - Costs arising from bankruptcy
or distorted business decisions before bankruptcy.
Market Value = Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial Distress

3. Financial Choices
Trade-off Theory - Theory that capital structure is
based on a trade-off between tax savings and distress
costs of debt.
Pecking Order Theory - Theory stating that firms prefer
to issue debt rather than equity if internal finance is
insufficient.

4. Pecking Order Theory
The announcement of a stock issue drives down the stock price because
investors believe managers are more likely to issue when shares are
overpriced.
Therefore firms prefer internal finance since funds can be raised without
sending adverse signals.
If external finance is required, firms issue debt first and equity as a last
resort.
The most profitable firms borrow less not because they have lower
target debt ratios but because they don't need external finance.

5. Pecking Order Theory
Some Implications:
Internal equity may be better than external equity.
Financial slack is valuable.
If external capital is required, debt is better. (There
is less room for difference in opinions about what
debt is worth).

6. Pecking Order Theory
Stewart Myers (1984)
• Managers are better informed than investors.
Investors might see an external equity
issuance a bad news about the
company, assuming that managers want
outside shareholders to share the loss, thus
investors will react to this issuance
negatively, increasing the issuance cost of
external equity. 6

7.  Firms therefore prioritize their sources of
financing according to the law of least
effort, or of least resistance: internal funds are
used first, and when that is depleted, debt is
issued, and when it is not sensible to issue any
more debt, equity is issued.
 This theory maintains that businesses adhere to
a hierarchy of financing sources and prefer
internal financing when available, and debt is
preferred over equity if external financing is
required.
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8. MM Version Three: with Multiple Frictions
• Taxes: mentioned earlier (in MM Version Two).
• Bankruptcy cost: direct costs (such as legal costs)
and indirect costs (such as reputation loss and
financial distress).
• Agency problems: [e.g.] risk-shifting  firm may
increase risk and thereby extract value from
existing bondholders. (Covenants could reduce
the problems)
• Free cash flow reduction: debt might reduce extra
cash in the firms hence alleviate management
deviations.
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9. PECKING ORDER THEORY
• Firm do not have any target capital structure and
there is no optimum capital structure.
• Assumption
Asymmetric information-Professional managers of the
firm are well equipped with more information when
compared to investors.

10. Why to prefer retained earnings more??
• Easy to use , cheaper & no transaction cost
• Avoid capital market regulations.
• Don’t have adequate reliable information about
capital market.
• The announcement of a stock issue drives down the
stock price because investors believe managers are
more likely to issue when shares are overpriced.
• Therefore firms prefer internal finance since funds
can be raised without sending adverse signals.
• Shareholders need not pay any personal taxes.
• No Interest - steady cash flow.
•

11. Why to prefer debt more??
• Tax deductibility of interest charges.

12. Outcome of the theory
• The most profitable firms borrow less not
because they have lower target debt ratios
but because they don't need external finance.
• Negative inverse relationship between
profitability and debt ratio.