8/18/2019 Thread Off Theory vs Pecking Order Theory

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Thread – off theory vs Pecking Order Theory

The Trade-off Theory of capital structure refers to the idea that a firm chooses

how much debt finance and how much equity finance to use by balancing cost and

benefits. Trade-off Theory claims that firm have an incentive to use debt to benefit

debt tax shield. n other word it can be stated that a firm has an incentive to turn debt

as the generation of annual profits allow benefiting from the debt tax shields.

Pecking Order Theory basically states that the cost of financing increases with

asymmetric information. !inancing comes from internal fund" debt and new equity.

#hen it comes to method raising capital company will prefer internal financing" debt"

and then issuing new equity as a last resort.

The $tudies by %elia and &na '()**+ on , '$/s+ in region of Portugal for

the period of *001 – ()), seek if Trade -Off Theory and Pecking Order Theories are

able to explain the capital structure decision of these firm. The finding show $/s

prefer internal financing compare to external financing. t can be because most

profitable firm able to retain profit over time" then they become less dependent on

debt. The studies show that $/s do not give great importance to the debt tax

shields and risk in their capital structure decision" distancing themselves from the

assumption off Trade of Theory. 2ut the finding also show that $/s ad3ust relatively

quickly" their actual debt ratio toward optimal debt ratio. This behaviour somehow

show that $/s adopting !inancing behaviour in accordance to the forecast of

Trade –Off Theory. The result obtained from the studies can be conclude that the

capital structure decision of $/s with the assumption of both Trade-Off Theories

and Pecking Order Theories. #hen $/s make considerable ad3ustment of their

actual debt toward optimal level of debt the $/s said to practising Trade Off

8/18/2019 Thread Off Theory vs Pecking Order Theory

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Theory. On the other hand" when more profitable" older $/s turn less to debt they

corroborate with the forecast of Pecking Order Theory.