Lecture 5

Question 1

What are the three methods of deciding debt vs. equity?

Answer 1

• Trade-off theory
• Pecking order theory
• Market timing theory

Question 2

What is the Trade-Off Theory?

Answer 2

• Too much debt increases the risk of financial distress (like bankruptcy)
• The goal is to find the “optimal” level of debt - where the benefits of debt (tax shield) just balance the costs (risk of distress)

Question 3

What is the Pecking Order Theory?

Answer 3

Firms should structure their capital according to the following rule to minimise the cost of funding:
- Use internal funding first (retained earnings) as the cheapest source
- Issue debt which is still less costly due to low risk/uncertainty and fixed returns to investors
- Equity should be issued as the last resort since it has the highest cost

Question 4

What is the Market Timing Theory?

Answer 4

• Managers issue debt or equity depending on current valuation of the company in the market and amount of information they have.
• Signalling Theory
• Adverse Selection Theory
• Assymetric information, CEO has inside information that shareholders don’t have access to

Question 5

What happens in the case of assymetric information - shares are undervalued?

Answer 5

Signalling Theory:
If the real value of the firm > price in stock market => undervalued => issue debt to signal undervaluation => CEO has been hiding (keeping) some good information that the firm will be successful in the near future with very high probability => investors demand for new shares => share price increases and the undervaluation disappears => firm becomes correctly priced

Question 6

What happens in the case of assymetric information - shares are overvalued?

Answer 6

Adverse Selection Theory:
If the real value of the firm < price in stock market => overvalued => issue equity at overpriced value => in the market other firms which are correctly priced are also issuing new shares this makes it difficult for investors to buy new shares as they can’t tell which firm is overpriced and which is correctly valued => low demand on shares decreases the price of shares for all firms => Correctly priced firms become “undervalued” and leave the market => Only previously overvalued firms remain in the market =>
As the price of shares are already down, these firms become correctly priced