What is the pecking-order theory and what are the implications that arise from this theory?

The pecking-order theory states that firms should first use internal financing, which includes
retained earnings. If the firm then requires external financing, it should issue the safer
securities, such as debt, first.

The implications of this theory are:

1. There is no target amount of leverage.
2. Profitable firms use less debt.
What should be the primary goal of the financial manager of a corporation? Explain why this
is appropriate?

The appropriate goal is to maximize the current value of the outstanding stock. This goal
focuses on enhancing the returns to the current stockholders who are the owners of the firm.
Other goals, such as maximizing sales or earnings, focus too narrowly on accounting profits
and ignore the importance of market values in managerial finance.

Discuss MM Propositions I and II in a world with taxes. List the basic assumptions, results,
and intuition of the model ?

Assumptions:
 Corporations are taxed at the rate TC, on earnings after interest.
 No transaction costs
 Individuals and corporations borrow at same rate.
Results:
 Proposition I: VL = VU + TCB
 Proposition II: RS = R0 + (B/S)(1 − TC)(R0 − RB)
Intuition:
 Proposition I: Because corporations can deduct interest payments but not dividend
payments, corporate leverage lowers tax payments, thereby increasing firm value.
 Proposition II: The cost of equity rises with leverage because the risk to equity rises
with leverage.