Question

1. Company A saved 1Billion dollars internal cash in 2001 and 2002. Their debt to value ratio is around 40% in both 2001 and 2002. In order to finance a project in 2003, which costs 3 billion dollars, the company used 1billion dollar internal cash. The company had 3 billion dollars internal cash before the project. The company’s cost of debt is same as cost of using internal cash. The market value of company at the end of 2003 is 150 Billion dollars and market value of equity is 90 billion dollars.

If you were told that the company is following pecking order theory, how would you evaluate company’s decision in financing the new project?

If you were told that the company is following trade off theory, how would you evaluate company’s decision in financing the new project?

Answer 1

Under the pecking order theory, the company uses the internal financing before the external debt financing. In the current case the company has exactly followed the same. I will evaluate by first seeing whether the company has internal financing available. If yes, whether the same was used in financing the project over external financing.

Under trade-off theory, the cost and benefits of the financing option are considered. In order to evaluate that separate cost and benefits of the internal financing and debts has to be calculated.

In the current case, under trade-off theory, it would be possible to, given that cost of equity and debt are same, select debt as option becasue it will give tax shield benefit. Hence all these matters will be considered while eveluating the project under trade off theory.