The pecking order theory and the trade-off theory of optimal capital structure lead to different predictions:
A)According to the trade-off theory, there is no target amount of leverage.
B)According to the pecking order theory, proﬁtable ﬁrms use more debt.
C)According to the trade-off theory, ﬁrms do not use internal funds to ﬁnance investments.
D)According to the pecking order theory, tax rates have no effect on leverage.
E)None of the above.

Question

Quizplus · Accepted Answer

The pecking order theory suggests that firms prefer to finance investments first with internal funds, then with debt, and finally with equity, implying that more profitable firms will use less debt, not more. The trade-off theory posits that firms balance the tax advantages of debt financing against the costs of potential financial distress, implying there is a target amount of leverage and that firms do use internal funds to finance investments. Therefore, none of the provided statements accurately describe the theories.

The Pecking Order Theory and the Trade-Off Theory of Optimal