Signaling Theory and Trade-off Theory in Capital Raising Decisions | CFA Level 1 Exam Preparation

Signaling Theory

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A firm is considering undertaking a project requiring $7 million of new capital. The managers of the firm consider the prospects of the project having a 36% rate of return extremely likely, with a small probability that the project will not recover anything invested. The firm's current debt ratio is 70% and market analysts have estimated that the tax benefits from an increase in the debt level will be far smaller than the increase in bankruptcy costs. The Signaling Theory implies that the firm will try to raise _______ capital. The Trade-off Theory implies that the firm will try to raise _______ capital.

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A. B. C. D.

D

Since additional debt does not create more benefits from tax shield than the losses anticipated due to increased bankruptcy costs, the Trade-off theory implies that the firm will try to raise equity capital for the project. On the other hand, since the prospects of the project are extremely favorable, Signaling Theory says that the firm would rather raise the capital through debt so that the profits from the project are shared on an equity basis only with the current shareholders.

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