Question

1. Company A saved 1Billion dollars of 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 of internal cash before the project. The company’s cost of debt is the same as the cost of using internal cash. The market value of the company at the end of 2003 is 150 Billion dollars and the market value of equity is 90 billion dollars.

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

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

Answer 1

Pecking order theory allows the company to use the internal financing before the external debt financing. In this case the company has has followed the same technique. To evaluate the same we will analyse the sequence of finance use. If the company has used internal financing before extrernal financing then it would be the correct way. As per pecking order theory.

As per trade-off theory, cost and benefits of the financing option need to be evaluated before choosing. First the costs and benefits of both the options need to be calculateds eparately.

In the current case, under trade-off theory, it would be possible to 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.