Explain what capital structure theory (or theories) best describes the following

Question

Explain what capital structure theory (or theories) best describes the following situations. Make sure to cite at least one of the required textbook chapters for each answer, and to cite at least two references for this section:

A CEO decides to borrow $50,000 in new debt, and the share prices rise dramatically. He then decides to sell half of his own personal shares, and when this is reported in the Wall Street Journal, the share prices drop dramatically in value.

The corporate tax rate rises from 35% to 45%, and the XYZ Corporation decides to issue more debt. A year later, bankruptcy laws are changed to become much stricter and costlier. XYZ then decides to pay back half of its debt.

A CEO named Joe Bigwig is known for living large with very expensive cars and a huge mansion. Joe is seeking a large loan from a bank to finance some new projects for his corporation. However, the bank becomes concerned when they find out that he recently used company funds to buy a brand-new company jet and also schedules numerous business trips to Hawaii and stays in five-star hotels. The bank tells Joe he will receive the loan only if he agrees to scale back on his personal expenses and not give himself or any other executives a raise until the loan is paid back.

Explanation / Answer

1) This situation clearly is a demonstration of pecking order theory. Equity is used as a last resort of financing and preference is given more to internal financing and debt capital. when a large amount of debt is already injected in capital structure then company resorts to use of equity. this does not go down well with investors who believe that the firm might be overvalued and managers are trying to take advantage of overvaluation. As a result, share prices fall.

2) This situation is an example of the trade off theory which gives preference to existence of bankruptcy costs. It allows bankruptcy cost to exist in context of using debt as tax shield. It states that there is an advantage to financing with debt, namely, the tax benefits of debt which clearly reduces the annual interest payment.

3) Since the CEO is seeking a large loan it may be assumed that his company primarily relies on debt financing in general. The theories that can be applied to this situation could be the MM proposition with taxes which states that optimal capital structure consists of 99.99% debt and also the pecking order theory which also undermines equity financing and opts for internal and debt financing.

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