Trade off theory

Objective of the theory:Identify the optimal debt-to-equity ratio as the level at which the two offset each other. It states:There is an advantage to financing with debt, The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases.

As the Debt equity ratio (i.e. leverage) increases, there is a trade-off between the interest tax shield and bankruptcy, causing an optimum capital structure, D/E*.

Pecking order theory

Suggested by Donaldson in 1961 Objective of the Theory:Prioritize the sources of financing for companies according to the cost of financing Assumption of theory:managers know more about their companies prospects, risks and value than outside investors.

Pecking order theory

Sources of Financing and Signals sent:1.Internal financing 2.Debt 3.equity