(c) (d) Explain briefly how trade-off theory differs from pecking order theory.
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Question
(c) (d) Explain briefly how trade-off theory differs from pecking order theory. (3 Marks) Kclanivalley Manufacturing Company has a total capital of Rs. I million and it carns profit of Rs.100,000 before interest and tax. The newly appointed financial manager wants to take a decision on its capital structure. He has taken the following capital structure information after studying the Sri Lankan capital market. Amount of Debt Rs. Debt Cost of CapitalEquity Cost of Capital at given level of 10% 10.5% 11% 496 4.5% 5% 5% 5.5% 6% 8% 200000 300000 400000 12.4% 13.5% 16% 20% 600000 1) What amount of debt the company should maintain according to the optimal capital structure decisions? Estimate the equity cost of capital according to Modigliani and Miller theory 2) (6 Marks) (e) The following financial information is extracied from ABC Company listed in the Colombo Stock Exchange. Rs. 1000,000 (300,000) 400.000) 300,000 Sales Variable operating cost Fixed operating cost EBIT Interest EBT Tax @40% EAT Preferred dividends Earnings available for common stockholders 200,000 120,000 Number of shares outstanding 50,000 Calculate the degree of finance leverage. 2) l) If EBIT decrease by 20%, what is your forecast of EPS?Explanation / Answer
(c) The trade of theory states that to get an optimal cost of capital, the company must increase its level of debt. According to this theory, the interest on debt is a tax deductible and the risk of taking debt is lower than that of equity. This is because debt has a lower cost than equity. This means the company can lower its WACC through debt financing. However, there is a level of debt above which financial distress risk increases which may actually offset the decrease to WACC. Hence the company should identify the right mix of debt and equity
The pecking order theory states that the company should first try to finance the project internally through the profits that it generates. In other words, the projects within the business should be funded with accumulated retained earnings. If internal funding is not available, then as a next step, the company should look at debt financing. Finally, as a last resort the company should look at issuing new equity.
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