Question

26. Leverage measures Most financial managers measure debt ratios from their companies' book balance sheets. Many financial economists emphasize ratios from market value balance sheets. Which is the right measure in principle? Does the trade-off theory propose to explain book or market leverage? How about the pecking-order theory?

correct answer

( trade off theory - market leverage) (a decision to reduce the likelihood of financial distress by retirement of debt means that existing debt is acquired at market value, and that the resulting decrease in interest tax shields is based on the market value of the retired debt. Similarly, a decision to increase interest tax shields by increasing debt requires that new debt be issued at current market prices.)

I don't understand what that means

thanks a lot

Answer 1

Trade off theory is based on the idea that a company when choosing between debt and equity to finance its capital structure, it chooses a level of debt which at which the benefit of tax on interest exceeds the cost of financial distress. The interest payment on debt is tax deductible so if a company is paying a certain rate of interest on debt then the after tax cost of debt is low and financial distress cost means that company is obligated to pay the interest every period no matter what the business condition is and if it does not pay it might create a situation of bankruptcy for the firm. Trade off theory should be analyzed on the basis of market value of debt and equity. Trade off theory does propose to explain market leverage. Pecking order theory states that managers have more information about the company than outsiders so, the order in which the managers choose to raise funds is Internal financing, debt and then equity. It shows that equity is less preferable a source for capital then the debt because the cost of equity arises because of the asymmetric information between managers and outside investors. Again, pecking order theory focuses on the market leverage as the level of debt in the capital structure will increase, the cost of external equity will also go up.