Question

Corporate Finance

2. (IS points) Compare the difference between MM proposition, trade-off theory, and pecking-order theory.

Answer 1

MM Proposition given by Modigliani and Miller is also known as static trade off theory. Both these economist argued in favor of debt financing, According to them, most governements provide tax benfits on firm's debt payments as interest is generally tax free. Hence they argued that it is profitable for firms to finance using debt rather then equity.

Pecking order theory laid stress on financing through retained earnings before resorting to debt from the market. According to this theory, financing from own resources is a signal of sound financial health of the firm. Also it protects the firm from the interest burden which falls upon the when it resorts to loan from outside sources.

Trade off theory is the previous version of MM proposition. This theory also comments about the debt-equity ratio balance in case of debt financing. It also says that debt financing is cheaper then equity financing as viewing from the point of tax benefits.However on the other hand on also needs to consider the bankruptcy cost of debt hence one should be careful in striking a proprer balance between debt-equity financing as well as tax benefit and bankruptcy cost of debt.