3.(30) Capital Structure Theory

While using debt may add pressure to a companys ongoing operations as a result of having to meet interest-payment obligations, it helps retain more profits within the company compared to using equity(A). That's because equity requires the sharing of company profits with equity holders. Using debt, companies need to pay only the amount of interest out of their profits. Using equity, on the other hand, the more profits a company makes, the more it has to share with equity investors.

To take advantage of such a debt-financing feature, companies often use debt to finance stable business operations in which they can more easily make ongoing interest payments and, meanwhile, retain the rest of the profits to themselves.

As long as using debt doesnt threaten the financial soundness of a company in times of difficulties, equity owners welcome certain debt uses to help enhance their investment returns.

Using debt helps lower a companys taxes because of allowable interest deductions(B). Tax rules permit interest payments as expense deductions against revenues to arrive at taxable income. The lower the taxable income, the less taxes a company pays. On the other hand, dividends paid to equity holders are not tax-deductible and must come from after-tax income. Therefore, tax savings help further reduce a companys debt financing cost, which is an advantage that equity financing lacks.

1) Comparing A with B, which statement is more credible claim to the value of debt financing? Why?

2) Among the theory of capital structure, the trade-off theory is a match between the tax reduction effect of debt and_______________________. 

 Please fill in in the sentence above.

3) What is the pecking order theory? What is its implication to the corporate financing decision?