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The theory proposes that the firm’s value is peripheral to financing
decision or the capitalisation decisions. The theory utilises the pattern of
investors in explaining the value of the firm. It suggests that value of a
company is not affected by use of leverage debt in the capital structure
under the arbitrage process (Modigliani and Miller, 1958). Assumptions made under this theory
is that it is based on perfect market conditions, whereby there are no
transaction costs in buying and selling of securities, investors are allowed to
buy and sell their securities, securities can be divided infinitely and
investors can rationally access information. These assumptions make it possible
to conclude that in a perfect market, the capital structure and the dividend
policy decisions have no impact on the value of the firm (Modigliani and
Miller, 1963). Sheikh and Wang (2010) are however critical of this assumptions
where they argue that they are non-pertinent in the practical situations. This
is because they ignore factors such as taxes, bankruptcy costs, information
asymmetry, agency costs, transaction costs and time varying financial market

Trade-off Theory

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The theory proposes that decision makers in an organisation engage in an
exercise of trying to equate the advantages of interest tax safeguard against
the present value of the feasible costs of financial distress. This involves
the decision maker evaluating the different costs and benefits of the
alternative leverage plans available to them (Myers, 2001). Myers (1984) one
of the major proponents of the trade-off theory champions for finding a common
ground between savings enjoyed by the firm through debt financing and the  minimisation of the agency costs , bankruptcy
costs and financial distress costs. The idea is to achieve the optimal
capital structure through striking a balance between the advantages received
from interests paid and the costs incurred in issuing debt. This implies that a
decision maker that chooses such an option is motivated by the idea of
maximising the company’s value by reducing the costs of the existing market distortions
(Jahanzeb, Bajuri, Karami and Ahmadimousaabad, 2014).

Chang, Lee and Lee (2009) contribute to the literature on the trade-off
theory by claiming that the greatest dilemma to this theory that the decision
makers face is deciding on the amount of debt that can be utilised to offset
tax implication without falling into the trap of excessive debt. This is
because a balance must be established between the present value of the tax
shields and costs of bankruptcy. Bankruptcy costs in this context relate to the
direct costs in legal and administrative expenses during bankruptcy period and
the indirect costs resulting from the reduction of the company’s market value
because of its inability to settle the debt obligations. The trade-off theory
can further be grouped into static trade-off theory and the dynamic trade-off
theory (Leary and Roberts, 2005).

Figure 1: Trade-off theory of capital structure. Source: (Brealey, Myers
and Allen, 2007)

 The static trade-off theory is
founded on the assumption that organisations have optimal capital structures that
can be determined by trading off the costs against the benefits of the firm
using debt and equity. The advantage of using debt as earlier discussed is the
tax shield the firm gets, but it can lead to future damage of capital structure
through the company accumulating much debt. This implies that the firm should
probably adopt a mixed type of fundingfor them to balance the benefits and
drawbacks of equity and debt financing (Butt, Khan, and Nafees, 2013). Agency
costs remain another important consideration under the static trade-off theory.

The agency costs arise from the conflicts of interest between the firm
stakeholders and the post imperfect information (Jensen, 1986).

As opposed to the other single period models, the dynamic trade- off
theory puts into consideration the aspect of time. This makes the model more
reliable in delivering the right finance decision because it takes into
consideration the financing margins that the company anticipates in the next
period. The financing margin in this context relates to the funds the firm
expects to raise, the funds the firm expects to pay out or both (Goldstein, Ju and
Leland, 2001).

The Pecking Order Theory

The pecking order theory proposes that information
costs arising from information failure between the insider and the outsider are
important enough to allow the management to offer security with minimum information
costs. Unlike
the other theories, the pecking order theory ignores the optimal capitalisation
starting point and instead adopts the verifiable fact that companies will
always prefer to use internal finance before seeking for external finance. It
further assumes that in the event the event the firm decides to seek external
finance, they will seek from an option that minimises the additional costs of
capital and of information asymmetry (Mostafa and Boregowda, 2014). To avoid
conflicts with investors, managers are more likely to adopt the safest route of
issuing debt than equity under the assumption that the company’s securities are
under-priced as compare to the perceived overpriced shares. This implies that
under the pecking order equity will be considered as the last resort source of
financing (Myers and Majluf, 1984).

According to Myers (1984), the theory utilises the market to book
ratio in evaluating investment opportunities. The researcher is critical of
the concurrent relationship between the market to book ratio and the capital
structure, whichmay be hard to reconcile with the fixed pecking order model. The
model assumes that intervals of high investment opportunities may increase
leverage towards the debt capacity to the level that high previous market to
book ratio concur with high previous investment. However, Fama and French
(2002) dispute this assumption by arguing that research shows that such phases
of high investment opportunities result to reduction in leverage.

Market Timing theory

The theory proposes that the present capital structure
of a company is the accumulative result of the past efforts to time the equity
market. This is
achieved through the firm issuing new shares when they perceive they have been
overpriced and repurchasing them back when they perceive they are undervalued.

This implies that both the historical market values and variation in stock
prices influence the capitalisation of a firm (Baker and Wurgler, 2002). This
version of the theory is based on the assumption that economic agents are
irrational, which causes the stock of the company to be varied and mispriced. The
underlying assumption to this theory category is that economics agents are
rational, which implies that the company will avoid information asymmetry by
issuing shares directly to the investors after positive information about the
company is released (Luigi and Sorin, 2009).

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