The static trade-off theory and the pecking order theory are two financial principles that help a company choose its capital structure. Both play an equal role in the decision-making process depending on the type of capital structure the company wishes to achieve. The pecking order theory, however, has been empirically observed to be most used in determining a company's capital structure.
Static Trade-Off Theory
The static trade-off theory is a financial theory based on the work of economists Modigliani and Miller. With the static trade-off theory, and since a company's debt payments are tax deductible and there is less risk involved in taking out debt over equity, debt financing is initially cheaper than equity financing. This means a company can lower its weighted average cost of capital (WACC) through a capital structure with debt over equity. However, increasing the amount of debt also increases the risk to a company, somewhat offsetting the decrease in the WACC. Therefore, the static trade-off theory identifies a mix of debt and equity where the decreasing WACC offsets the increasing financial risk to a company.
Pecking Order Theory
The pecking order theory states that a company should prefer to finance itself first internally through retained earnings. If this source of financing is unavailable, a company should then finance itself through debt. Finally, and as a last resort, a company should finance itself through the issuing of new equity. This pecking order is important because it signals to the public how the company is performing. If a company finances itself internally, that means it is strong. If a company finances itself through debt, it is a signal that management is confident the company can meet its monthly obligations. If a company finances itself through issuing new stock, it is normally a negative signal, as the company thinks its stock is overvalued and it seeks to make money prior to its share price falling.