Question

The trade-off theory relies on the threat of financial distress. But why should a public corporation ever have to land in financial distress? According to the theory, the firm should operate at the top of the curve in Figure 1. Of course, market movements or business setbacks could bump it up to a higher debt ratio and put it on the declining, right-hand side of the curve. But in that case, why doesn't the firm just issue equity, retire debt, and move back up to the optimal debt ratio?

Vi = Vy + TcXD Present value of tax shield on debt Financial distress costs Maximum firm value V Actual firm value Value of the firm V = Value of firm with no debt Optimal amount of debt Total debt (D) According to the static theory, the gains from the tax shield on debt is offset by financial distress costs. An optimal capital structure exists that just balances the additional gain from leverage against the added financial distress cost.

Answer 1

Usually when the firm raises its capital it does it in its optimal capital ratio. in usual circumstances the companies park their net income after distributing dividends in reserves and surplus which forms a part of the equity so whenever a company starts a project the only capital that they need to raise is debt capital, because equity portion is always there in the form of capital + reserves and surplus. The company will always try to operate in a situation where they have optimal capital budget and where the value of the firm is at its maximum as the dot on the pink line suggests. If a situation arises where the firm has taken up huge debt and has moved to right hand side of the dot, the best case can be to issue equity to either employees or friends and families to bring it back to the optimal level. Raising equity from the market is not as easy as we think, it includes as lot of information which needs to be answered to the existing investors, cost of raising equity is high as the underwriting cost by the investment banks is high. cost of equity is higher than the cost of debt which will increase the wacc and decrease the value of the firm. As per the pecking order theory equity is the last form to raise capital preceded by debt and internally generated funds being the first in the preference to raise capital. Market may look it as a bad news for the investors as they may think that the company has dried up all the reserves and no bank is lending them debt so they are raising equity.

Firms in these situations try to reduce debt by replacing costly debts with cheaper ones or by raising equity through family and friends or existing shareholders as going to the market can be costly.