The Pecking Order ,Static trade off & signalling theory

The Pecking Order Theory

 The pecking order theory describes how firms raise capital. This theory says that firms are
driven by information asymmetries and transaction costs to use internally generated capital first before turning to more expensive sources of financing. Once their internal sources are used, then firms will use debt (where the information asymmetry problem is less severe)
first and then as a last resort equity.

The pecking order theory is able to explain why firms tend to depend on internal sources of funds and prefer debt to equity if external financing is required. Thus, a firm’s leverage is not driven by the trade-off theory, but it is simply the cumulative results of the firm’s attempts to mitigate information asymmetry.

As per Myer’s Pecking order theory firm will take debt in which they have to give least information to the market

Order

                                                 1.      Retained Earning

      2.      Private debt

      3.      Public debt

      4.      Equity

The Static Trade off theory

This theory deals with the cost of distress and positive effects of tax. According to this theory D/V is optimal when Marginal Benefit of tax shield are not greater than marginal cost of bankruptcy or

PV (Tax Shields) = PV (Expc Bankruptcy Costs)

Using High leverage in the capital structure cannot be explained.

Signalling theory –As per this theory by raising public debt companies provide signal to the market that there are many investors and project is good.