Capital Markets Are Perfect - Essay Example

In tradeoff theory, the search is for an optimum capital structure. The tradeoff is between the interest tax shield, bankruptcy costs, and agency costs. The firm would seek the optimum debt ratio that maximizes the value of the firm. It, therefore, balances the marginal present values of interest tax shields against bankruptcy costs and agency costs. The theory, therefore, predicts the mean reversion of the actual debt ratio towards a target or optimum and also predicts a cross-sectional relation between average debt ratios and asset risk, profitability, tax status, and asset type.

In pecking order theory, there is no optimal debt ratio. Due to asymmetric information and signaling problems associated with issuing equity, financing policies follow a hierarchy, with a preference for internal over external financing and for debt over equity. The debt ratio is therefore a cumulative result of hierarchical financing over time. 2. Managers are prohibited from trading in the shares of the firm. This prevents them from going against the interests of the firm, for example, short-selling the shares before announcing bad news about the firm even though the firm is doing well. 3. 3.

Investors use the face value of debt held by the company to tell whether the firm is successful (type A) or unsuccessful (type B).4. By changing the capital structure, the firm alters the perceived market value of the firm even if the true value of the firm remains the same. 1-period interest rate r t = 0 t=1V0 V1Market perception Truth is revealedManager's compensation, M, paid out at the end of the period t=1: V1 if V1 DM = (1 + r)0V0 + 1 V1 - C if V1 < D0, 1: positive weights of the value of the firm: 
r: one-period interest rate
V0, V1: value of the firm at t=0 and t=1
VA: the value of successful type firm at t = 1
VB: the value of unsuccessful type firm at t = 1
D: face value of debt
D*: maximum amount of debt an unsuccessful firm can carry without going bankrupt
C: penalty paid if bankruptcy occurs, if V < D

• If D > D*, the market perceives the firm to be successful (type A) at t = 0 and vice versa.
• VA > VB

Manager’s compensation of a type A firm, MA, at t = 1:

(1 + r) γ0 VA/(1 + r) + γ1 VA = γ0 VA + γ1 VA if D* < D  VA (tell the truth)
MA =
(1 + r) γ0 VB/(1 + r) + γ1 VA = γ0 VB + γ1 VA if D < D* (lie)